Use Caution Before Purchasing Real Estate in an IRA

Purchasing an investment property with the funds in an IRA has gained popularity since the housing crash of 2008. At the time, prices were, and in some cases still are, attractively low. At the same time, many investors that had been laid off during the recession found themselves looking for ways to bring in income while coincidentally rolling 401(k) balances into IRAs. Others were still reeling from the stock market crash, and were leery of financial markets. As a result, they started turning to something the felt they better understood, real estate. Whether purchasing physical real estate is a sound investment decision is a topic for another day, however, for those that it is appropriate the ability to use IRA assets to do so is a question we are occasionally asked.

The basic premise is fairly straight forward: use your retirement funds to invest in physical real estate and enjoy tax advantaged growth and income generated by the property. For many investors, their IRA balances represent a large source of liquidity, which can be used to fund the transaction rather than having to finance the project or support it out of cash flow or other savings. While this strategy may seem attractive on the surface, the reality is that while the strategy can work under the right circumstances, the strict rules surrounding IRAs makes them a tricky, if not outright poor, shelter for this type of activity.

First, let’s discuss the specifics of how this strategy typically gets implemented. There are several IRA custodians around the country that specialize in “Self-Directed” IRAs, which will work with investors that want to hold alternative assets in their IRA, such as real estate or physical gold bullion. You may also use a Roth IRA, should you wish. It’s important to note that while it’s legal to hold these types of assets in an IRA, the only prohibited investments are life insurance, collectibles/antiques and some types of derivative contracts, the majority of custodians do not permit physical holdings inside IRAs because they don’t have the infrastructure needed to properly handle those types of assets. Therefore, in order to purchase a piece of real estate, investors would first need to open an IRA at a custodian designed to handle it and then roll funds into it. Bear in mind, the custodian will only be handling the custodian duties, and will not provide any advice or help beyond that, hence the term “Self-Directed”.

Once the IRA has been established and funded the next step is to purchase the property. This is where things start getting tricky. The IRA, which can be thought of as its own entity that exists for your benefit, will be who actually buys the property, and who’s name is on the title. It’s important to note that all of your funds being used in the purchase have to come from the IRA. You cannot personally pay for anything. More on this to come later. It is possible to finance the purchase, so long as it’s a non-recourse loan, or to take on partners but it’s important that tax attorneys are involved to be sure the deals are structured properly. A loan will also lead to an unrelated business income tax (UBIT), which applies despite the tax preferences usually associated with IRAs.

There are also restrictions on what properties you can buy with an IRA. The first restriction is against self-dealing, which means you can’t purchase a property that is owned by you or any disqualified person. A disqualified person would include you and your linear relatives (think grandparents through grandchildren) or their spouses, any entity you own at least 50% of, or any fiduciary such as your investment advisor. You also cannot enjoy any indirect benefits from the property. That means you can’t purchase a vacation home with the intent to rent it out most of the year, but to use it occasionally for yourself or any of the above listed disqualified persons. You are also prohibited from using the property as collateral for a personal loan, as the property belongs to the IRA.

Once the property has been selected and purchased no disqualified person can actively provide any services for the property. That means neither you nor any other disqualified person can work on the rehabilitation of the property, which removes the ability to gain “sweat equity”. If you are planning to rent the property out you can’t even act as the land lord, or actively participate in finding a tenant. Instead, you must hire an unrelated management company. Furthermore, all expenses of maintaining and/or improving the property must be paid for by the IRA, through the custodian. You can’t pay for anything out of non-IRA assets. Similarly, all income generated, such as rents, must flow through the custodian directly back to the IRA.

So what happens if you violate any of these restrictions? Generally, the assets in the IRA involved in the violation are treated as if they’d been distributed, and are included in that year’s taxable income to the traditional IRA owner. In other words, the IRA stops being an IRA. The taxation of Roth IRAs in this situation are a bit more complicated, and depend on the amount of time the Roth has existed. If the owner is under 59.5 years old there could also be a 10% early distribution penalty. Furthermore, the tax preferences granted to IRAs, either tax deferred growth for a traditional IRA or tax free growth for a Roth IRA, will be forfeited going forward. As you can see, it’s a stiff penalty for a violation that can easily be tripped accidentally if you aren’t well versed in the tax code.

Speaking of the tax code, there are some other draw backs to this strategy that should be discussed. Investors that choose to purchase investment properties in their IRA will give up many tax deductions commonly associated with real estate, such as depreciation and interest deductions. They will also lose out on the opportunity to pay taxes on future gains, when the property is sold, at the lower long term capital gains rate, as all distributions from traditional IRAs are taxed as ordinary income. Roth IRA distributions on the other hand, are typically tax free if you follow the distribution rules.

Another aspect of traditional IRA investing that becomes more complicated when purchasing investment properties relates to the Required Minimum Distributions (RMD) that are required to start once you’ve turn 70.5 years old. In order to determine how much you need to take out of the account, and therefore pay income taxes on, you need to know what the value of the assets in the IRA was at the end of the prior year. That means annual property appraisals will be required. It also means that there has to be enough liquid assets in the IRA to distribute each year, such as cash or other securities or else you’ll be required to distribute portions of ownership of the property. That will quickly become cumbersome from an accounting perspective. Fortunately, Roth IRAs don’t require RMDs, which removes some administrative burdens, however your heirs will be required to take RMDs out of your Roth after your passing.

To summarize, while it is legal to own illiquid assets, such as real estate, in your IRA it is not a strategy that should be taken lightly. The many restrictions and administrative costs can quickly offset any potential tax savings, especially when you consider the loss of common tax deductions. Bear in mind also that you can gain exposure to the real estate market in your IRA through the use of publicly traded Real Estate Investment Trusts (REITs), which contain a diversified portfolio of properties, without the restrictions or costs of the physical asset. In either case, you should be sure to have a trusted team of advisors, such as a financial advisor, attorney and accountant, to help you make the best decision for your situation prior to making any investments.