Entrust Learning Center > Keyword: real estat > The Elements Of Tax Free And Tax Deferred Investing Involving Real Estate And Notes

The Elements Of Tax Free And Tax Deferred Investing Involving Real Estate And Notes

The simplest part about using IRAs and Qualified Plans as sources of funds to invest in Real Estate and Notes is that it is like any real estate transaction using a third party entity as the owner.

The best analogy is when your company buys a note or real property, the company officers or designee need to sign and approve documents and authorize events to go forward.  It works the same way for your IRA or qualified plan.  There are some rules about who can benefit from the deal and who can’t, and when.  That even varies among IRAs and Qualified Plans have some different rules altogether.  The bottom line is, that you can do it and it is straight forward.

Some Basic Rules Regarding IRA Assets

• Your IRA or Plan can’t deal with you or members of your family who are ascendants or descendants or their spouses.  This means parents and children, their spouses and you and your spouse are out.
• You cannot receive a current benefit from the IRA Assets.  This means you can’t live on the property, even for one second.  You can’t receive the rents from it, or income from a note.  You can only receive that income (and pay those expenses) that are proportionate to your IRAs or plans investment.  So if you have yourself, an IRA and a plan that owns a property or note in equal parts, then you must allocate income and expense as 1/3 each.
• Qualified plans assets, such as office building invested in by a plan can have certain part allocated to having you rent space for the purposes of the plan.
  

Other rules will follow as we go through the process.

About Real Estate in an IRA

First of all we set up the scenario of real people and real deals:

Larry Heller is a Broker and is interested in purchasing additional real property for investment purposes.

Larry locates the property.  He has done so by checking through the MLS for potential rehabs in an area he is familiar with.  The property is a 36 unit apartment building, and has land adjacent to it available for expansion.

As part of the funding he is going to use his own cash, funds in the Profit Sharing (401(k)) plan for the real estate brokerage firm, a “C” corporation, of which he is the majority shareholder, and his Traditional IRA.  Larry has found out that because his Traditional IRA is made up of pre-tax dollars, he can roll the cash he needs from the IRA over to the Profit Sharing Plan.  (He will leave the private placements and notes in the IRA, as his custodian is providing the servicing for those assets.)  Larry can do this because the tax laws changed in 2002 to permit this.  Larry feels that it is more convenient to do this transaction through the qualified plan for the following reasons:

He is the Trustee of his own plan, and can do the closing personally and use the funds from a single source, rather than involving the custodian of his IRA when he doesn’t need to.

Because this is an apartment building, Larry recognizes that there may be a liability issue concerning tenants.  Although he has sufficient insurance based on his personal risk profile, the qualified plan has the anti-alienation provision, which will protect his qualified plan assets from creditors.

Because Larry does his own recordkeeping, and will be able to collect all the rents, and divide them into his personal account and the profit sharing plan, without having to hire a property manager to do the same thing. (He actually will have his bookkeeper do this for the plan).

Larry wants to move quickly.  The purchase contract shows him as the buyer.  Because he knows that until the actual close of escrow, the sales contract is assignable, until closing there is no issue of self dealing or prohibited transaction involving his IRA or Plan.  The terms of the deal are all cash for $720,000 and earnest money of $7,200 is provided by Larry to the Seller, Judy Hasenauer through escrow.

Larry will fund half of the purchase personally.

Escrow is opened at Brentwood Escrow for the property, and the deposit is taken.  Although it is sometimes customary for escrow to just hold on to the check, in this case the deposit is made to the escrow account.  Escrow is to close in 60 days.

Larry also engages American Title (ATCO), and he asks for a preliminary title report.  Simultaneously, he knows that in order to have part of his IRA funds transferred, from his self directed IRA to his own company’s Profit Sharing 401(k) Plan, he needs to have those funds rolled over. 

He completes a written rollover request and sends it to the IRA custodian’s administrator.  Because there is sufficient cash, he doesn’t need to ask for liquidating any liquid assets. As the self directed IRA is provided by the same administrator who provided him with his self directed qualified 401(k) plan, and rollover is completed in one day.  Normally the rollover process would take two to four weeks.

Larry asks ATCO for the copy of the deed which will Larry asks ATCO for the copy of the deed which will recorded in the purchasers’ names:

• The vesting will show 50% undivided interest in subject property in the name of Larry Heller as a married person as his separate property, and the Larry Heller Profit Sharing 401(k) plan for the remaining 50%.
• At closing the Settlement statement provides a breakdown of the cost and charges allocated among the buyers and sellers.  The earnest money deposit is split:  $3,600 remains in escrow, and $3,600 is refunded to Larry Heller.  The refund to Larry Heller is for the portion that his Plan has an interest in, otherwise it would be considered a contribution.  Larry will make a check to escrow for the amount needed for the 50% purchase including $3,600 which he was refunded personally.
  

The sale closes and Judy is happy with the deal, and Larry now has the property in 50% each in his and his Plan’s name.

The rental agreements for the apartments have been assigned to Larry and his plan equally.  Larry advises the renters that check need to be made to his plan.  Larry’s bookkeeper receives the payments and keeps accurate records of them.  The bookkeeper will divide the income in exact proportion between Larry and his plan, and write a check for Larry’s signature to be made to him personally.   Expenses for the apartment building, such as hazard insurance, taxes and repairs will be divided pro-rata between the Plan and Larry.  Larry has the ability to write check on the spot for any repairs or other expenses from the trust money market account he established at his brokerage.  Because his pro-rata Plan income is $40,000 per year and pro-rata expenses are only $7,000, he has his Plan purchase discounted mobile home paper with $25,000, as the cash flow permits.

The next year, Larry’s income is $50,000 from his brokerage business.  Because he receives a W-2 he can have the company contribute 25% of his W-2 income or $12,500 to his Profit Sharing Account.  The plan has the 401(k) feature, and he can therefore defer 100% of compensation to a maximum $16,500 to his 401(k) account, for a total of $29,000.

Larry is interested in the tax -free feature of Roth IRAs.  Because it is in his interest to never have to pay tax again on investments in his Roth IRA, he realizes that having cash or assets at a low basis makes sense, especially if the assets have a high return.

Larry also is aware that he can convert the assets in his Traditional IRA to a Roth IRA, because he is under the $100,000 income limit for doing the Roth conversion.
 
Having purchased some notes at discount in his qualified plan, Larry also wants to convert some of those to a Roth IRA.  Because his plan has an in-service withdrawal provision, Larry can roll these notes to a traditional IRA and also convert those notes into the same Roth IRA.

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