FEATURE ARTICLE, MAY 2006

RETIREMENT PLANS MAKE GOOD INVESTORS
IRAs and other Qualified Plans can be good investment vehicles to purchase commercial real estate.
Jerry Jarrett

Planning for a comfortable retirement requires shrewd decision making and portfolio diversification. One way professionals in commercial real estate can use their extensive knowledge of the industry to benefit their retirement plan is to use an IRA or Qualified Plan (401(k)) funds to invest in commercial and other types of real estate.

Single family and multifamily homes, apartment buildings, co-ops, condominiums, commercial property, improved or unimproved land, whether its leveraged or unleveraged, may be purchased by a Qualified Plan or IRA. An IRA’s purchase of commercial real estate offers the same logistics and benefits as if the property were owned by an individual.

The purchase and management of the property is straightforward. After establishing a truly self-directed IRA, the investor locates the property he desires to own and negotiates the purchase with the seller. Terms are agreed to and the contract is executed in the name of the IRA. The IRA custodian/administrator then works with the closing attorney or title company to ensure that title to the property is vested properly to show ownership by the IRA. Standard closing documents are executed and funds for the closing are wired to the escrow account in advance of the actual closing.

Assuming that the property is revenue producing, the management agent for the property pays necessary expenses on the property and the net rental income is forwarded to the IRA custodian/administrator and credited to the client’s account. These funds grow tax-deferred, and possibly tax free depending on the type of account.

When the investor desires to sell the property, the transaction is completed just like the purchase. The investor markets the property and negotiates terms with a prospective buyer. When a deal is made, the contract is again executed in the name of the IRA. Standard closing documents are executed at closing and proceeds from the sale are sent to the IRA custodian/administrator and credited to the client’s account.

As with all things related to the IRS, there are rules that apply to transactions inside your IRA. They are fairly straightforward, but vitally important as the penalties for committing a prohibited transaction are severe. There are rules to follow prior to acquisition of the property and rules to follow while the property is owned by the IRA.

The IRA cannot purchase property that is or has been owned by the IRA holder, his or her spouse, or any lineal ascendant or descendant of the IRA holder. This means that an IRA cannot buy property from the holder’s parents, grandparents, children, grandchildren, or those same relations to a spouse. As far forward or backwards as you have living relatives or active estates, the IRA cannot do business. Additionally, the IRA cannot purchase property from companies owned by this same group of people. There are some other requirements around companies that are controlled by this group of disqualified individuals that can be reviewed in IRS publication 590, “Individual Retirement Arrangements,” available through the IRS website, www.irs.gov.

Once the property is owned by the IRA, there is a similar set of rules regarding who can deal with the property. The same group of disqualified individuals and business entities may not rent or actively manage the property. This means that a doctor cannot purchase a medical building and then rent that building to his or her practice. It also means that the IRA holder cannot have his real estate management company as the management agent for the property.

So what can the IRA holder do to ensure that the property is running to his satisfaction?  Primarily, the investor can secure the tenants for the property and negotiate the terms of the lease. Expenses for marketing and leasing will be paid by the IRA directly to the providers of the services. Additionally, the investor will negotiate the terms of the contract with the management agent. All of this ensures that the property is filled and managed according to the requirements of the investor.

There may be cases where the IRA does not have sufficient funds to purchase the property outright or the investor may simply wish to leverage the purchase of the property. In both of these cases, the IRA can still participate.

The IRA can partner with a variety of other funding sources, such as other IRAs, other non-sheltered funds, and even the IRA holder itself. In these cases, the IRA will hold an undivided interest in the property proportional to the amount of funds the IRA put into the deal. For simplicity sake, assume a $500,000 purchase price without closing costs. If the IRA contributes $250,000 to the purchase, it would own a 50 percent undivided interest in the property. The other $250,000 is contributed by the other members in the deal; and the revenue/expense requirement is proportional to the contribution on each side. The IRA can partner with the IRA holder as long as this partnering is from the inception of the deal. The IRA will never be able to purchase the IRA holder’s interest in the property and vice versa.

If debt is going to be used in the deal, the loan to the IRA needs a no recourse provision. The IRA holder cannot personally guarantee the debt instrument and the additional assets of the IRA cannot guarantee the debt. Only the subject property can be collateral for the note. In this case, the loan is to the IRA itself and mortgage payments are made from the IRA. For a bank to be interested in the loan, it obviously needs to have positive cash flow. If the IRA holder is bringing debt to the deal to finance their portion of ownership, the loan cannot subject the IRAs ownership interest to foreclosure. This is the most difficult type of financing to secure as most lenders do not want stipulations on their interest in the property.

One additional point should be made regarding debt financing. Depending on the type of sheltered account the holder’s investing from, gains on the sale of debt financed property may be subject to the debt-financed income provisions of Unrelated Business Income Tax (UBIT) laws. UBIT is a complex concept and should be discussed thoroughly with your tax advisor prior to investing.

This type of investing may not be for everyone, but for real estate professionals, investing retirement funds in the markets they work in every day can have dramatic gains.

Jerry Jarrett is a managing member of Atlanta-based Entrust Retirement Services of Georgia, LLC.

©2006 France Publications, Inc. Duplication or reproduction of this article not permitted without authorization from France Publications, Inc. For information on reprints of this article contact Barbara Sherer at (630) 554-6054.