Combining self-directed Roth and Tradition IRA's in house flip


J

Jake29

A friend of mine has a self-directed Roth IRA and a self-directed
Traditional IRA, and he uses a combination of funds from both of them to
buy, rehab, and then re-sell real estate (mostly single family homes, one or
two a year) -- for a profit. The profits go back into his self-directed
Roth and Traditional IRA's, and are either tax deferred or are tax free,
depending on which IRA's the profits went back into.

I had a question and/or suggestion, and I am wondering if a future deal
could be structured as follows to enable the profits to go
disproportionately into the Roth rather than into the Traditional IRA.

Here's my example or suggestion using made up numbers:

The Roth has $10,000 in it, and the Traditional IRA has $90,000 in it. He
buys the property in the name of the Roth for $50,000 and he has an
additional $50,000 in expenses for repairs/rehab, holding costs, selling
costs, etc.. So, the Roth needs a total of $100,000 to do the deal. The
Roth puts up $10,000 to buy the property in the name of the Roth, and the
Traditional IRA lends the Roth the remaining $90,000 at a modest but fair
interest rate to pay for the purchase, repairs, etc. After all costs and
expenses (including purchase price, holding costs, repairs/rehab, selling
costs, and interest on the loan from the Traditional IRA to the Roth, etc),
the Roth sells the property for $130,000 -- a $30,000 profit.

My question is, can the deal be done like this, where the entire $30,000
profit goes to the Roth, even though the Roth only put up $10,000 of the
total cost of the project?

If so, all of the $30,000 profit would go into the Roth and would be tax
free.

The Traditional IRA would earn some interest on the loan to the Roth, which
would go back into the Traditional IRA and would be tax deferred. But,
since the Traditional IRA did not own the property -- it only loaned money
to the Roth -- the profit from the re-sale would all go to the Roth as the
owner of the property.

Is this correct, or am I missing something here?

The alternative, which is how he is doing it now, would be for the Roth and
the Traditional to be partners in the purchase with a $10,000/$90,000 split
according to their contributions to the deal, and the profits being split
1/10 back into the Roth and 9/10 back into the Traditional IRA. But, that
would mean that most of the gains from the sale would be tax deferred rather
than tax free.
 
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S

Stuart A. Bronstein

Jake29 said:
A friend of mine has a self-directed Roth IRA and a
self-directed Traditional IRA, and he uses a combination of
funds from both of them to buy, rehab, and then re-sell real
estate (mostly single family homes, one or two a year) -- for a
profit. The profits go back into his self-directed Roth and
Traditional IRA's, and are either tax deferred or are tax free,
depending on which IRA's the profits went back into.

I had a question and/or suggestion, and I am wondering if a
future deal could be structured as follows to enable the profits
to go disproportionately into the Roth rather than into the
Traditional IRA.
[snip]

My question is, can the deal be done like this, where the entire
$30,000 profit goes to the Roth, even though the Roth only put
up $10,000 of the total cost of the project?
Probably not. Under normal partnership rules, profits and losses
are divided in proportion to the investment made. This can be
varied, but there has to be an actual economic reason to change it.

I suppose it could be set up so the regular IRA lends money to the
other for whatever the legal minimum interest would be, and the
Roth could get the rest of the profit. But that would have to be
documented with paperwork. They can't just arbitrarily allocate
profits.
 
J

Jake29

Stuart said:
Jake29 said:
A friend of mine has a self-directed Roth IRA and a
self-directed Traditional IRA, and he uses a combination of
funds from both of them to buy, rehab, and then re-sell real
estate (mostly single family homes, one or two a year) -- for a
profit. . . .
[snip]

My question is, can the deal be done like this, where the entire
$30,000 profit goes to the Roth, even though the Roth only put
up $10,000 of the total cost of the project?
Probably not. Under normal partnership rules, profits and losses
are divided in proportion to the investment made. This can be
varied, but there has to be an actual economic reason to change it.

I suppose it could be set up so the regular IRA lends money to the
other for whatever the legal minimum interest would be, and the
Roth could get the rest of the profit. But that would have to be
documented with paperwork. They can't just arbitrarily allocate
profits.
Thanks Stuart. That last paragraph is what I meant -- that there would be
no partnership. The Roth IRA would be the sole owner of the property. The
Traditional IRA would have no share in the ownership of the property -- it
would just be lending money to the Roth and earning the interest on the
loan.
 
J

JoeTaxpayer

Thanks Stuart. That last paragraph is what I meant -- that there would be
no partnership. The Roth IRA would be the sole owner of the property. The
Traditional IRA would have no share in the ownership of the property -- it
would just be lending money to the Roth and earning the interest on the
loan.
Using self-directed IRAs to buy real estate has a number of issues to
contend with. One is self-dealing. As Stu answered, all deals need to be
in proportion if more than one account is involved. Using one to lend to
another is walking on thin ice in terms of breaking the rules, and
breaking the shell of the IRAs. Especially when there's no motive to do
so except to concentrate the profits into the Roth. In your proposal,
the Roth is borrowing, likely paying minimum interest, but producing all
the gain. If sold before the loan is paid, the profit is still taxed
even if inside the Roth. Have you considered this?

There have been many court cases of convoluted deals set up to do
nothing more than shift money into one's Roth. I see here an actual
underlying investment, but in an audit, the 'shifting' aspect will be
analyzed very closely.
 
J

Jake29

Jake29 said:
Stuart said:
Jake29 said:
A friend of mine has a self-directed Roth IRA and a
self-directed Traditional IRA, and he uses a combination of
funds from both of them to buy, rehab, and then re-sell real
estate (mostly single family homes, one or two a year) -- for a
profit. . . .
[snip]

My question is, can the deal be done like this, where the entire
$30,000 profit goes to the Roth, even though the Roth only put
up $10,000 of the total cost of the project?
. . . ,
I suppose it could be set up so the regular IRA lends money to the
other for whatever the legal minimum interest would be, and the
Roth could get the rest of the profit. But that would have to be
documented with paperwork. They can't just arbitrarily allocate
profits.
Thanks Stuart. That last paragraph is what I meant -- that there
would be no partnership. The Roth IRA would be the sole owner of the
property. The Traditional IRA would have no share in the ownership
of the property -- it would just be lending money to the Roth and
earning the interest on the loan.
I have been looking further into this and I found something that may come
into play here called "unrelated debt financed income".

Here is a link that talks about some of this:
http://www.irs.gov/pub/irs-tege/eotopicn86.pdf -- as it would relate to a
tax exempt organization that borrows money for an investment - and how much
of the profits can also be considered to be tax exempt. There may be
parallels here that would apply to the idea that I proposed above, where a
Roth IRA borrows money from a Traditional IRA to buy, rehab, and re-sell a
property fro profit.

One thing that is buried somewhere in the link above has to do with "working
capital" - money that is loaned to the tax exempt entity that is working
capital and is not a purchase money mortgage. It seemed to indicate that
if, for example, a Roth IRA bought a property entirely with its own funds,
and then borrowed unsecured money as "working capital" (not a mortgage or a
purchase money loan) to do the repairs and cover other expenses, and then
sold the property at a profit -- MAYBE the unsecured working capital loan
wouldn't be counted toward "unrelated debt financed income", and wouldn't be
taxable.
 
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J

Jake29

JoeTaxpayer said:
Using self-directed IRAs to buy real estate has a number of issues to
contend with. One is self-dealing.
I am actually not concerned about the "self-dealing" issue. Both IRA's are
independent of the person who funded the IRA, and neither IRA would be
dealing with the person who funded the IRA, or a spouse of that person, or a
descendant of that person, etc. -- which are examples of the self-dealing
exclusions.
 
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