Real estate may be owned in your personal name, in a business name, or in a trust. You may have heard of revocable living trusts, corporations, LLCs, series LLCs, or limited partnerships. Here’s a quick guide to where you should own different types of properties.
1. Personal Residence
Your home should be owned in your revocable living trust. A living trust is an excellent choice to own your personal residence as the property can pass under the terms of your trust upon your death and your heirs won’t need to go to probate court to transfer ownership. If your residence is owned in your personal name it can only pass to your children/heirs after you’ve gone to probate court which requires far more legal fees and time than setting up a trust now. For homes with significant equity you may want to consider a domestic asset protection trust which can protect the equity in the home from personal creditors.
2. Rental Property
Your rental property should be owned in an LLC. Rental properties generate income and wealth but they can also create liabilities. If a rental property is owned in your personal name everything that happens on the home creates personal liability to you and a plaintiff can go after all of your personal assets, income, and wages. On the other hand, if a rental property is owned in an LLC the plaintiff will be required to sue the LLC and can’t go after the LLC owner personally. In certain states where you have lots of properties you may want to consider a series LLC which provides liability protection in the LLC between multiple properties such that if something happens to one property in the series LLC it doesn’t effect the other properties in the series LLC. An LLC owned by one person or a married couple isn’t too difficult to manage and generally doesn’t require a separate LLC tax return. Instead, you report the property and its profit/loss on your personal return in the same way you ‘d report the profit/loss if you owned it in your personal name. In most instances, limited partnerships should not be used to hold rental properties as your tax losses and write offs are restricted when you own them in a limited partnerships.
3. Land or Second Home
Your land or second home should be owned in your revocable living trust. Again, this helps keep your assets coordinated with your estate plans and outside of probate court. For land or second homes with significant equity you may want to consider a limited partnership or domestic asset protection trust which can protect the property from the owner’s personal liabilities. Generally, an LLC is not used unless the property itself creates liability. For example, if you rent your second home or cabin you may want an LLC for liability protection but most second homes or parcels of land do not create liability and therefore do not need an LLC.
4. Where Should Properties Never Be Held
Except for short short term real estate holds (under one year) properties should not be owned in a s-corporation and should never be held in a c-corporation. Additionally, we rarely recommend clients use land trusts to own property for asset protection purposes as land trusts provide little actual asset protection beyond making the owner of the property difficult to determine at the county records.
There are lots of options and many nuances to how you should own your real estate. For a more detailed and specific analysis for your properties please contact the law firm for an estate and asset protection plan that fits your needs. We can also assist with deed transfers to get your properties into the right place.
The prohibited transaction rules are the most important rules to understand when you self-direct your retirement account. These rules restrict not what investments your retirement plan may acquire but whom your plan may transact with.
How It Happens
A prohibited transaction occurs when a retirement plan (e.g. self directed IRA or 401k) transacts with a disqualified person. IRC § 4975. A transaction is pretty easy to identify and is defined in the code as a sale, lease, exchange, payment, or other transfer of money from a retirement plan. If that transaction is with a disqualified person then the retirement plan has engaged in a prohibited transaction. The consequence of a prohibited transaction for an IRA is distribution of entire IRA while the consequence to a 401(k) or other employer based plan is a 15% excise tax on the amount involved and an additional 100% penalty if the transaction is not corrected. Regardless of the type of retirement account you are self-directing, the consequences are significant. IRC § 4975 (c)(3), IRC § 408 (e)(2)(A). IRC § 4975 (a),(b).
Often times, a disqualified person is generically referred to as a family member. While that definition can be accurate, it really can cause problems when applied as some family members are disqualified (e.g. spouse of plan owner) while others are not (e.g. brother of plan owner). Also, it can be really confusing to determine when a company is disqualified to a retirement plan or when partners are disqualified. Because of the confusion, I’ve created a disqualified person diagram to help sort out the details. If a party is in red, that means they are a disqualified person and that your retirement plan cannot transact with them. If the party is green, that means they are NOT disqualified and your retirement plan may transact with them.
Keep in mind that a self-dealing prohibited transaction can also arise if any disqualified party personally benefits from a retirement plans investments. In summary, you should avoid all transactions with disqualified persons and should seek legal counsel whenever a disqualified person is involved in any retirement plan investment.
A Self-Directed IRA is an IRA (Roth, Traditional, SEP, Inherited IRA, SIMPLE) where the custodian of the account allows the IRA to invest into any investment allowed by law. These investments typically include; real estate, promissory notes, precious metals, and private company stock. The typical reaction I hear from investors is: “Why haven’t I ever heard of self-directed IRAs before, and why can I only invest my current retirement plan into mutual funds or stocks?” The reason is that the large financial institutions that administer most U.S. retirement accounts don’t find it administratively feasible to hold real estate or non-publicly traded assets in retirement plans.
What Can a Self-Directed IRA Invest Into?
Under current law, a retirement account is only restricted from investing in the following:
Collectibles such as art, stamps, coins, alcoholic beverages, or antiques IRC 408(m);
And, any investment that constitutes a prohibited transaction pursuant to ERISA and/or IRC 4975 (e.g. purchase of any investment from a disqualified person such as a close family member to the retirement account owner).
The most popular self-directed retirement account investments include; rental real estate, secured loans to others for real estate, small business stock or LLC interest, and precious metals such as gold or silver. These investments are all allowed by law and can be great assets for investors with experience in these areas.
When self-directing your retirement account you must be aware of the prohibited transaction rules found in IRC 4975. These rules don’t restrict what your account can invest in, but rather, whom your IRA may transact with. In short, the prohibited transaction rules restrict your retirement account from engaging in a transaction with someone who is a disqualified person to your account. A disqualified person to a retirement account includes the account owner, their spouse, children, parents, and certain business partners. So, for example, your retirement account could not buy a rental property that is owned by your father since a purchase of the property would be a transaction with someone who is disqualified to the retirement account (e.g. father). On the other hand, your retirement account could buy a rental property from your cousin, friend, sister, or a random third-party, as these parties are not disqualified persons under the rules.
The rationale behind the prohibited transaction rules is that the federal government doesn’t want tax advantaged accounts conducting transactions between parties who are close enough to the account owner that there could be a transaction designed to avoid or un-fairly minimize tax by altering the true fair market value/price of the investment. The consequence of a prohibited transaction is disqualification of the retirement account as of January 1 of the year the prohibited transaction occurred. In a typical self-directed IRA investment, your IRA custodian holds your investment in their company name for your IRAs benefit (e.g. property is owned as ABC Trust Company FBO John Smith IRA) and receives the income and pays the expenses for the investment at the account owner’s direction and instruction.
What is an IRA/LLC?
Many self-directed retirement account owners, particularly those buying real estate, use an IRA/LLC as the vehicle to hold their retirement account assets. An IRA/LLC is a special type of LLC, which consists of an IRA (or other retirement account) investing its cash into a newly created LLC. The IRA/LLC is managed by the IRA owner and the IRA owner then directs the LLC investments and the LLC takes title to the assets, pays the expenses to the investment, and receives the income from the investment. There are many restrictions to the IRA owner being a manager (such as not receiving compensation or personal benefit) and many laws to consider so please ensure you consult an attorney before establishing an IRA/LLC. For more details on the IRA/LLC structure, the cases, and the structuring options, please refer to my prior blog post here.
Most self directed IRA owners know that their self directed IRA cannot conduct transactions with themselves or certain family members (e.g. spouse, kids, parents, etc.). Most self directed IRA owners also know that their self directed IRA cannot do business with a company they own or that their disqualified family members own 50% or more of. However, one of the most confusing areas of the prohibited transaction rules are the prohibited transaction rules which apply to business partners or officers, directors, and/or highly compensated employees of companies the IRA owner or family members are personally involved in. For example, what if I own a business with a partner? Can my IRA enter into a transaction with that business partner if we aren’t family? Well, it depends.
Disqualified Person Analysis
To analyze the rules you first need to determine whether the company in which the business partner (or officer, or director) is involved in is a company that is owned 50% or more by the IRA owner or their disqualified family members. IRC 4975 (e)(2)(E),(H), (I). So, for example, if my wife and I owned 60% of the business and our partner owned 40% of the business, then this company would be owned 50% or more by disqualified persons.
Once we know that the company is owned 50% or more by disqualified persons, we need to identify all of the officers, directors, highly compensated employees, and 10 % or more owners of that company. In sum, all of these persons are disqualified to the IRAs of the 50% or more owners. In the example above, since my business partner owned 40% of the company, he is a 10% or more owner and as a result he is a disqualified person to my IRA (since my wife and I own 50% or more of the company).
Let’s look at another example. Say that I am a 35% owner of a business with a few other partners who are not disqualified family members to me. Since I do not own 50% or more of this company, it doesn’t matter who the other partners, officers, or directors, are, as they are not disqualified to my IRA as part of this rule since my ownership (and that of my disqualified family members) is below 50%.
As a final example, let’s say that I own 70% of a company and that I have a partner who owns 5%. Under the rule, my partner or fellow shareholder does not have 10% or greater ownership and as a result they are not disqualified to my IRA. However, if that 5% owner was the President of my company then they would be a disqualified person.
These rules can be tough to understand when you read the code, but if you take the two step analysis you can easily determine what partners, officer, directors, or highly compensated employees are disqualified to your IRA.
Here’s also a quick summary of the rule from my book where I took the text of the tax code and put it into plain language.
Key Persons in Company Owned 50% or More by Disqualified Persons
An officer, director, or 10% or more shareholder, or highly compensated employee (earns 10% or more of the company’s wages) of a company owned by the IRA owner or other disqualified persons. IRC § 4975 (e)(2)(H).
Before investing with someone who is an officer, director, highly compensated employee, or a shareholder/owner in a company you are involved in, please consult these rules and where you are un-clear, seek the advice of competent counsel.
When IRA-owned property is held for rent, the management of the rental property must be structured such that rental income is received by the IRA and expenses are paid by the IRA. The IRA owner and other disqualified persons (e.g. IRA owner, spouse, etc.) cannot personally be the “middle man” by paying expenses personally or by collecting the rent in their personal account and then forwarding the funds to the IRA. There are essentially three different methods whereby the IRA may be structured to properly collect rent and pay expenses.
Three Methods to Manage the Property
1. Manage directly through the IRA. Money goes to the IRA custodian and expenses are paid by the custodian at the direction of the IRA owner.
2. Property Manager. The IRA hires a property manager who manages the property and receives the income and pays property expenses. Cash flow is returned to the IRA.
3. IRA/LLC. Under the IRA/LLC, the IRA owner is the manager of the IRA/LLC and receives income and pays expenses from an IRA/LLC checking account. The IRA/LLC structure is very common in IRA owned real estate investments.
First, the IRA may be receiving the income directly and paying the expenses. This method involves a lease between the IRA and the tenant directly. Under this method, the tenant pays rental income to the IRA (e.g. ABC Trust Company FBO Sally Jones IRA) and sends the actual payment to the IRA custodian and the custodian then deposits that income into the respective IRA. If expenses are due, the IRA owner will need to direct the custodian to pay them by completing a written form (e.g. payment authorization letter) and instructing the IRA custodian as to the expenses to be paid from the IRA. There is usually a fee each time an instruction letter is issued to a self directed IRA custodian. This method can be tedious and can be fee intensive and as a result is not the most common way of managing a rental property held by an IRA.
Second, the IRA hires a property manager who receives the rental income to the property and pays the expenses to the property. The property manager cannot be a disqualified person to the IRA owner and the property manager will typically take a percent of the rental income collected as payment for their services. Under this method the IRA enters into an agreement with the property manager and the property manager then enters into leases with respective tenants. The IRA receives rental income minus property expenses and fees charged by the property manager.
Third, many IRA owners with rental property decide to use a structure known as an IRA/LLC. Under the IRA/LLC structure, the IRA invests into a newly created LLC and the IRA’s investment is then the ownership of the LLC. The IRA will invest an amount designated by the IRA owner into the LLC, and then funds are typically deposited into an LLC checking account at a bank selected by the IRA owner.
IRA/LLC Structure for Real Estate
The IRA owner then, as manager of the LLC, signs the contract for the LLC to purchase the real estate. The property should close in the LLC name with funds from the LLC bank account and the LLC then in turn rents the property, receives the income and pays the expenses all from the LLC checking account. The LLC is entirely owned by the IRA and all funds in the LLC checking account must eventually be returned to the IRA when the IRA owner desires to take a distribution.
Regardless of the method used to own and manage the IRA owned rental property, the property cannot be leased to a disqualified person. So, for example, the IRA cannot purchase a property and allow the IRA owner’s son to lease the property as that lease would be a transaction with a disqualified person which results in a prohibited transaction.
In addition to prohibited transactions that are involved in leasing the property to family members, the IRA owner should closely analyze any leasing arrangement to a company where the IRA owner or other disqualified persons are owners of the IRA or company. For example, any lease to a company that is owned 50% or more by the IRA owner or other disqualified persons would constitute a prohibited transaction. IRC § 4975(e)(2)G).
In summary, there are many different ways to manage a rental property owned by your IRA. Make sure you are implementing one of these methods and that you are managing the IRA’s income, expenses, and properties properly.
This article is an excerpt from Mat Sorensen’s book, The Self Directed IRA Handbook.
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Mat’s book is the most practical and comprehensive self directed IRA guide in our industry. Reading this handbook should be the first step for any alternative asset investor, investment sponsor, or trusted advisor that seeks to become informed about how to maximize the value of IRAs.