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investing in foreclosures with self directed ira

Can You Use Your Self-Directed IRA for Rehabbing or Purchasing Foreclosed Real Estate?

Self-directed IRAs are quickly gaining popularity by virtue of their tax advantages and ability to invest in a variety of alternative assets. One area that’s bursting with opportunity for self-directed IRA owners is real estate. There are plenty of opportunities to buy a typical listed property and sell it for immediate profit or collect the ongoing rental income.

Are you willing to go a step further for even greater return potential? Rehabbing a distressed property or purchasing foreclosed real estate can be lucrative investments. Both rehabs and foreclosures, however, have their own set of considerations to take into account.

Rehabs in a Self-Directed IRA

Thanks to HGTV, rehabbing seems fun and pretty easy. Investing in rehabs, however, is actually an advanced strategy with many issues to consider, particularly when using a self-directed IRA.

No Sweat Equity. Although you may want to roll up your sleeves and work, an IRA owner’s role is limited to management decisions like choosing vendors and contractors. The IRA Prohibited Transaction Rules forbid disqualified persons (including the IRA owner and certain family members) from certain types of self-dealing transactions that would provide them either direct or indirect benefit. This means you can’t do any renovations or repairs yourself.

Possible UBIT. The Unrelated Business Income Tax (UBIT) comes into play if the self-directed IRA receives business income. Typical passive investment income, such as rental and interest income, is generally exempt from UBIT. Rehabbing and flipping a property, however, may be considered a business activity that is subject to UBIT depending on factors such as the volume and frequency of rehabs and flips.

Separation of Funds. All renovation expenses or income from selling or renting the property (including foreclosed properties) must be paid for or returned to the self-directed IRA. In order to maintain an IRA’s tax-exempt status, it’s important to keep personal funds separate from your IRA’s funds.

Foreclosures in a Self-Directed IRA

Purchasing a foreclosed property is a great way to take advantage of real estate’s return potential, but it’s trickier than a typical real estate transaction.

Legal Issues. There may be issues stemming from the mortgage default of a previous owner, such as liens and unpaid taxes, which could extend to the property and transfer to the new owner. The previous owner may also have some residual rights throughout the foreclosure process, and there may be certain redemption laws applicable in the state where the property is located. Due to the complex nature of a foreclosure transaction, it may be a good idea to consult an attorney or other real estate professional.

IRA Prohibited Transaction Rules. These rules prevent the self-directed IRA from buying foreclosed property from a disqualified person. Furthermore, the IRA can only rent or sell the property to someone who is not a disqualified person.

Financing the Purchase. With foreclosures, a buyer often needs to act quickly on a deal and purchases are typically all cash. However, if an IRA doesn’t have enough funds to do so the purchase can be financed with a non-recourse loan. This means that if the loan goes into default, the only recovery for the lender is the property, not the IRA. Financing the purchase can also lead to UBIT.

Whether you’re mulling over a foreclosure or a rehab project, it’s important to do your research before actually investing your hard-earned retirement funds. Determine the property’s real market value and rent potential by looking at things like comparable sales in the area and the condition of surrounding properties. Know about the pertinent laws and restrictions, follow the rules, and don’t hesitate to engage a professional for advice. Being educated about your investments is key to building future wealth within a self-directed IRA.