Buying a Retirement Home With Your Self-Directed IRA

One hand holding a pair of keys to the right of another hand with its palm opened upwards.A common self-directed IRA question is, “Can I buy a future retirement home with my IRA?” Yes, you can buy a future retirement home with your IRA, but you need to understand the rules and drawbacks before doing so. First, keep in mind that IRAs can only hold investments and you cannot go buy a residence or second home with your IRA for personal use. However, you can buy an investment property with a self-directed IRA (aka “SDIRA”) that you later distribute from your IRA to your self personally then begin to personally use.

 

The strategy essentially works in two phases. First, the IRA purchases the property and owns it as an investment until the IRA owner decides to retire. You’ll need to use a SDIRA for this type of investment. Second, upon retirement of the IRA owner (after age 59 ½), the IRA owner distributes the property via a title transfer from the SDIRA to the IRA owner personally and now the IRA owner may use it and benefit from it personally as the asset is outside the IRA. Before proceeding down this path, an SDIRA owner should consider a couple of key issues.

Avoid Prohibited Transactions

The prohibited transaction rules found in IRC Section 4975, which apply to all IRA investments, do not allow the IRA owner or certain family members to have any use or benefit from the property while it is owned by the IRA. The IRA must hold the property strictly for investment. The property may be leased to unrelated third parties, but it cannot be leased or used by the IRA owner or prohibited family members (e.g., spouse, kids, parents, etc.). Only after the property has been distributed from the self-directed IRA to the IRA owner may the IRA owner or family members reside at or benefit from the property.

Distribute the Property Fully Before Personal Use

The property must be distributed from the IRA to the IRA owner before the IRA owner or his/her family may use the property. Distribution of the property from the IRA to the IRA owner is called an “in-kind” distribution, and results in taxes due for traditional IRAs. For traditional IRAs, the custodian of the IRA will require a professional appraisal of the property before allowing the property to be distributed to the IRA owner. The fair market value of the property is then used to set the value of the distribution. For example, if my IRA owned a future retirement home that was appraised at $250,000, upon distribution of this property from my IRA (after age 59 ½) I would receive a 1099-R for $250,000 issued from my IRA custodian to me personally.

Because the tax burden upon distribution can be significant, this strategy is not one without its drawbacks. Some owners will instead take partial distributions of the property over time, holding a portion of the property personally and a portion still in the IRA to spread out the tax consequences of distribution. This can be burdensome though, as it requires appraisals each year to set the fair market valuation when you take a distribution of the property (which is done at fair market value). While this can lessen the tax burden by keeping the IRA owner in lower tax brackets, the IRA owner and his/her family still cannot personally use or benefit from the property until it is entirely distributed from the IRA. Many investors will use an IRA/LLC and will transfer the LLC ownership over time from the IRA to the IRA owner to accomplish distribution.

For Roth IRAs, the distribution of the property will not be taxable as qualified Roth IRA distributions are not subject to tax. For an extensive discussion of the tax consequences of distribution, please refer to IRS Publication 590-B.

Additionally, keep in mind that the IRA owners should wait until after he/she turns 59 ½ before taking the property as a distribution, as there is an early withdrawal penalty of 10% for distributions before age 59 ½.

As stated at the outset of this article, while the strategy is possible, it is not for everyone and certainly is not the easiest to accomplish. As a result, before purchasing a future retirement home with your IRA, self-directed investors should make sure they understand that they cannot have personal use while the property is owned by the IRA and that there are taxes due from traditional accounts when you later take the property as a distribution.

3 Critical Legal Tips When Buying a Business

Every buyer of a small business should consider the following three key legal issues when acquiring a business.

1. Buy Assets and Not Liabilities.

Most small business purchases are done as what are called “Asset Purchases”. In an Asset Purchase the buyer of the business acquires the assets of the business only. The assets include the goodwill, name, equipment, supplies, inventory, customers, etc. According to the terms of a properly drafted Asset Purchase Agreement, the assets do not include the prior owner’s business liabilities (the known or unknown). Under an Asset Purchase the buyer typically establishes a new company which will operate the business. This new company is free from the prior company’s liabilities and actions.

A “Stock Purchase” on the other hand occurs when the buyer acquires the stock or LLC units of the existing business. There are a few downsides to acquiring a business under a stock purchase. First, if you buy the stock or units of an existing company then you get the existing assets AND the existing liabilities of the acquired company. Since a new buyer hasn’t operated the business it is impossible for them to accurately quantify the existing liabilities. The second downside to a Stock Purchase is that the new owner of the company takes the current tax position of the departing owner when it comes to writing off equipment and other items in the company at the time of purchase. The downside to this is that the seller of the business may have already fully written off these items leaving the new business owner with little business assets to depreciate (despite a significant financial investment). If, on the other hand, the buyer acquired the “assets” in an Asset Purchase the buyer would depreciate and expense those assets as the new business owner chooses and in the most aggressive manner possible. Bottom line, an Asset Purchase has less liability risk and has better tax benefits that will allow the buyer to generate better tax write-offs and deductions over the life of the business.

2. Negotiate For Some Seller Financed Terms.

Many small business purchases include some form of seller financed terms whereby the seller agrees to be paid a portion of the purchase price over time via a promissory note. Seller financing terms are excellent for the buyer because they keep the seller interested and motivated in the buyer’s success since business failure typically means that the buyer wont be able to fully pay the seller. If the seller gets all of their money at closing then the seller is typically less interested in helping transition the business to the new owner as the seller has already been paid in full. Also, if the seller misrepresented something in the business during the sale that results in financial loss to the buyer, the buyer can offset the loss or costs incurred by amounts the buyer owes the seller on the note. In sum, the seller financed note gives the buyer some leverage to make sure the value in the business is properly and fairly transferred.

3. Conduct Adequate Due Diligence.

While it may go without saying that a buyer of a business should conduct adequate due diligence, you would be surprised at how many business purchases occur simply based on the statements or e-mails of a seller as opposed to actual tax returns or third party financials showing the financial condition of the business. A few due diligence items to consider are; get copies of the prior tax returns for the company, get copies of third party financials, make the seller complete a due diligence questionnaire where the seller represents the condition of the business to the buyer (similar to what you complete when you sell a house to someone). A lawyer with experience in business transactions can help significantly in conducting the due diligence and in drafting the final documents.

Buying an existing business is not only a significant financial commitment but is also a significant time commitment. Make sure the business is something worth your time and money before you sign. Oh, and make sure you get a well drafted set of purchase documents to sign.

Roth IRA Distributions Before Age 59 ½

Every Roth IRA account owner knows that the main benefit of the Roth IRA is that there are no taxes due on withdrawals taken after the account owner is 59 ½. However, what taxes or penalties apply to distributions taken before the Roth IRA owner reaches 59 ½?

Roth IRA distributions before age 59 ½ are broken into two categories, contributions and earnings. 

Contributions Can Be Withdrawn Before 59 ½ Without Tax or Penalty

The first first category is Roth IRA contributions. This category is distinct because these amounts have been subject to tax before the funds were included in the Roth IRA. The amounts withdrawn from a Roth IRA that do not exceed the amounts of Roth IRA contributions are not subject to taxes or penalties upon early distribution from the Roth IRA. However, any amounts distributed in excess of the Roth IRA contributions, which would typically be the investment returns, are subject to taxes and the early withdrawal penalty of 10%. 

This is an excellent perk as it allows Roth IRA owners to take money back that they contributed to the Roth IRA without worrying about penalties or taxes. 

Earnings Are Subject to Tax the 10% Early Withdrawal Penalty

Amounts withdrawn before 59 ½ that comprise the Roth IRA’s earnings are subject to tax and a 10% early withdrawal penalty. IRC § 408A(d)(2)(A) & Treasury Reg. §1.408A-6, Q&A-1(b). “Earnings” is the amount over the sums you have contributed to the Roth IRA, and is essentially your investment returns and gains. 

Since there are taxes AND penalties on the earnings, you should only take distributions when absolutely necessary. 

Example of Roth IRA Distribution Before 59 ½

For example, let’s say a Roth IRA owner is 45 and has a Roth IRA with $65,000. This balance consists of $35,000 in Roth IRA contributions and $30,000 in earnings or investment returns. If the Roth IRA owner took a distribution of the entire account then $35,000 would NOT be subject to early withdrawal penalties as this amount comprised Roth IRA contributions where taxes have been paid already. However, the remaining $30,000 distributed represents investment returns/gains made in the Roth IRA and would be subject to early withdrawal penalties of 10% and must be also be included in the taxable income of the Roth IRA owner. As a result, Roth IRA owners under age 59 ½ should avoid distributions of their Roth IRA in excess of their contributions. 

Back Door Roth IRA Rules and Steps

Roth IRAs can be established and funded for high-income earners by using what is known as the “back door” Roth IRA contribution method. Many high-income earners believe that they can’t contribute to a Roth IRA because they make too much money and/or because they participate in a company 401(k) plan. Fortunately, this isn’t true.

While direct contributions to a Roth IRA are limited to taxpayers with income in excess of $120,000 ($189,000 for married taxpayers), those whose income exceeds these amounts may make annual contributions to a non-deductible Traditional IRA and then convert those amounts over to a Roth IRA. Our IRA company – Directed IRA – can help those who want a self-directed “back door” Roth IRA, but the strategy can be done with almost anyone who wants a Roth IRA.

Examples

Here’s a few examples of earners who can establish and fund a Roth IRA:

  1. “I’m a high-income earner and work for a company who offers a company 401(k) plan. I contribute the maximum amount to that plan each year. Can I establish and fund a Roth IRA?” Yes, even though you are high-income, and even though you participate in a company 401(k) plan, you can establish and fund a Roth IRA. You just have to use the “back door” method.
  2. “I’m self-employed and earn over $200,000 a year; can I have a Roth IRA? Isn’t my income too high?” Yes, you can contribute to a Roth IRA despite having income that exceeds the Roth IRA income contribution limits of $189,000 for married taxpayers and $120,000 for single taxpayers. You just have to use the “back door” method.

The Process

The strategy used by high-income earners to make Roth IRA contributions involves the deposit of non-deductible contributions to a Traditional IRA, and then converting those funds in the non-deductible Traditional IRA to a Roth IRA. This is often times referred to as a “back door” Roth IRA. In the end, you don’t get a tax deduction on the amounts contributed, but the funds are held in a Roth IRA and are tax-free upon retirement (just like a Roth IRA). Here’s how it works:

Step 1: Fund a new non-deductible Traditional IRA.

This IRA is “non-deductible” because high-income earners who participate in a company retirement plan (or who has a spouse who does) can’t also make “deductible” contributions to an IRA. However, the account can be funded by non-deductible amounts up to the IRA annual contribution amounts of $5,500 for 2018 ($6,000 for 2019 and forward). The non-deductible contributions mean you don’t get a tax deduction on the amounts contributed to the Traditional IRA. Don’t worry about having non-deductible contributions though, as you’re converting to a Roth IRA, so you don’t want a deduction for the funds contributed. If you did get a deduction for the contribution, you’d have to pay taxes on the amounts later converted to Roth. You’ll need to file IRS form 8606 for the tax year in which you made the non-deductible IRA contributions. The form can be found here.

If you’re a high-income earner and you don’t have a company-based retirement plan (or a spouse with one), then you simply establish a standard deductible Traditional IRA, as there is no high-income contribution limit on Traditional IRAs when you don’t participate in a company plan.

Step 2: Convert the non-deductible Traditional IRA funds to a Roth IRA.

In 2010, the limitations on Roth IRA conversions, which previously restricted Roth IRA conversions for high-income earners, was removed. As a result, all taxpayers are able to covert traditional IRA funds to Roth IRAs since 2010. It was in 2010 that this “back door” Roth IRA contribution strategy was first utilized as it relied on the ability to convert funds from Traditional to Roth. It has been used by tens of thousands of Americans since.

If you have other existing Traditional IRAs, then the tax treatment of your conversion to Roth becomes a little more complicated as you must take into account those existing IRA funds when undertaking a conversion (including SEP and SIMPLE IRAs). If the only IRA you have is the non-deductible IRA, then the conversion is easy because you convert the entire non-deductible IRA amount over to Roth with no tax on the conversion. Remember, you didn’t get a deduction into the non-deductible Traditional IRA so there is not tax to apply on conversions. On the other hand, if you have an existing IRA with $95,000, and you have $5,000 in non-deductible Traditional IRA contributions in another account that you wish to convert to Roth, then the IRS requires you to convert your IRA funds in equal parts deductible (the $95K bucket) and non-deductible amounts (the new $5k) based on the money you have in all Traditional IRAs. So, if you wanted to convert $10,000, then you’d have to convert $9,500 (95%) of your deductible bucket, which portion of conversion is subject to tax, and $500 of you non-deductible bucket, which isn’t subject to tax upon once converted. Consequently, the “back door” Roth IRA isn’t well suited when you have existing Traditional IRAs that contain deductible contributions and earnings from those sums.

There are two workarounds to this Roth IRA conversion problem, and both revolve around moving the existing Traditional IRA funds into a 401(k) or other employer-based plan as employer plan funds are not considered when determining what portions of the Traditional IRAs are subject to tax on conversion (the deductible and the non-deductible). If you participate in an existing company 401(k) plan, then you may rollover your Traditional IRA funds into that 401(k) plan. Most 401(k) plans allow for this rollover from IRA to 401(k), so long as you are still employed by that company. If you are self-employed, you may establish a Solo or owner-only 401(k) plan, and rollover your Traditional IRA into this 401(k). In the end though, if you can’t roll out existing Traditional IRA funds into a 401(k), then the “back door” Roth IRA is going to cause some tax repercussions, as you also have to convert a portion of the existing Traditional IRA funds, which will cause taxes upon conversion. Taxes on conversion aren’t “the end of the world” though, as all of the money that comes out of that Traditional IRA would be subject to tax at some point in time. The only issue is it causes a big tax bill, so plan carefully.

The bottom line is that Roth IRAs can be established and funded by high-income earners. Don’t consider yourself “left out” on one of the greatest tax strategies offered to Americans: The Roth IRA.