What a self-directed IRA is
Every IRA has a custodian that holds its assets. Most custodians only offer publicly traded securities. A self-directed IRA uses a custodian that also permits alternative assets, including real estate, private partnerships and LLC interests, and private loans. The tax rules are the same as for any IRA of that type: traditional IRAs grow tax-deferred, and qualified withdrawals from Roth IRAs are generally tax-free.
The word self-directed refers to the investment choices, not to the custody. You choose the investments; the custodian holds the assets, processes the paperwork and reports values to the IRS. Self-directed custodians generally do not evaluate whether an investment is any good, so the diligence is entirely yours.
Two ways IRA money reaches apartment buildings
For most investors, owning a passive interest in a professionally managed offering is far simpler than owning a building inside an IRA, because the sponsor handles operations and the IRA simply holds an interest.
- Investing in a syndication or fund: the IRA buys an LLC or partnership interest in a private offering, just as an individual would. The subscription documents are signed in the name of the IRA, for example “ABC Trust Company FBO Jane Smith IRA,” and distributions are paid back into the account.
- Owning property directly: the IRA buys a building outright, with title held in the name of the IRA. Every expense, from property tax to repairs, must be paid from the IRA, and all rent must flow back into it. You cannot do the work yourself or use the property personally.
Prohibited transactions and disqualified persons
The most serious risk with a self-directed IRA is a prohibited transaction under Section 4975 of the tax code. These rules bar the IRA from dealing with disqualified persons, a group that includes you, your spouse, your parents and grandparents, your children and grandchildren and their spouses, and entities controlled by any of them, as well as certain advisors and fiduciaries.
Examples of prohibited transactions include buying property from yourself or a family member, selling IRA property to them, lending money between the IRA and a disqualified person, personally guaranteeing an IRA loan, living in or vacationing at IRA-owned property, and paying IRA expenses with personal funds. The consequence can be severe: in many cases the entire IRA is treated as distributed as of January 1 of the year the transaction occurred, with income tax and possibly penalties due.
UBTI and UDFI: the tax that leverage can trigger
IRAs are generally exempt from tax on investment income, but there are exceptions. Unrelated business taxable income, or UBTI, can arise when an IRA earns income from an active business. More relevant for apartment investors is unrelated debt-financed income, or UDFI. When property is bought with borrowed money, the share of income and gain attributable to the debt can be taxable to the IRA.
Most multifamily syndications use mortgage financing, so an IRA investing in one may receive UDFI. The IRA, not the account owner, owes the tax and files Form 990-T when gross unrelated business income exceeds the annual threshold, currently $1,000. Depreciation and other deductions that flow through on the K-1 often reduce or eliminate the taxable amount in the early years, but a sale can produce a taxable gain. Ask the sponsor for an estimate and have your CPA review it.
Traditional vs. Roth for real estate
Inside a traditional IRA, real estate gains are tax-deferred, but withdrawals are taxed as ordinary income, and the tax benefits that make real estate attractive in a taxable account — depreciation that shelters income and lower long-term capital gains rates — are largely wasted. Required minimum distributions can also be awkward when the IRA holds an illiquid interest that cannot easily be sold to raise cash.
A Roth IRA can be more appealing for growth-oriented private investments, because qualified withdrawals, including the gains, are generally tax-free. Either way, think about how the illiquidity of a multi-year offering fits your distribution timeline, and whether the account has enough cash to cover fees and any taxes the IRA itself owes.
Practical considerations
A few details make the difference between a smooth investment and an expensive mistake:
- Custodian fees: self-directed custodians charge setup, annual and transaction fees that are paid from the IRA. Compare schedules before you choose.
- Valuations: the custodian must report a fair market value each year, so expect to provide the sponsor’s valuation of your interest.
- Timing: transfers between custodians and funding a private investment can take several weeks. Start before the offering’s funding deadline.
- Checkbook IRA LLCs: some investors set up an IRA-owned LLC to make investments faster. It adds flexibility and adds risk, because the account owner manages the LLC and is responsible for avoiding prohibited transactions.
- Solo 401(k)s: self-employed investors may use a self-directed solo 401(k) instead. These plans have different rules, including an exemption from UDFI on certain real estate debt, which is worth discussing with an advisor.
