You have found the perfect investment property, the price is low and the seller wants to unload it. However, you don’t have the cash to purchase real estate except in your IRA.
If you just take the funds out of your IRA to purchase the real estate, it is a taxable distribution which is subject to federal income taxes. And if you are under age 59½ and do not meet any of the exceptions for distributions, then you also have a 10% penalty tax for early withdrawals. Can you use your IRA to directly purchase that piece of real estate without triggering any taxes?
Most financial institutions have an internal rule that only financial securities such as stocks, bonds and cash are allowable investments in an IRA. However, there are certain investments that are not prohibited in an IRA under the federal rules. The most common IRA prohibited investments are in the general category of collectibles which include stamps, coins, art and antiques. Certain bullion coins are not considered prohibited investments.
In addition, under the federal rules, real estate is not considered a prohibited investment. In certain circumstances, you can avoid both the income tax and the penalty tax by actually purchasing investment real estate within your IRA. Your first challenge is to locate a financial institution that is willing to allow a real estate investment in your IRA. Usually, you can find one online.
You must be careful when investing IRA funds in real estate. Often these financial institutions do not always tell you the rules regarding what you can and cannot do with the real estate that is in your IRA. Under the Internal Revenue Code there are certain activities that you cannot engage with your IRA. These activities are called prohibited transactions which include:
You can not loan money to or borrow money from your IRA.
You can not sell property to or buy property from your IRA.
You can not use your IRA assets as security for a personal loan.
You can not receive goods or services from or provide goods or services to your IRA.
If you engage in any of these or other prohibited transactions, your IRA is deemed to be distributed to you on the first day of the tax year of the transaction. This means that you would have to pay income taxes not only on the amount invested in the real estate, but also on the entire balance of your IRA. In addition, if you were under the age of 59½, you would also have the 10% penalty tax.
The prohibited transaction that catches most people off guard and that is often times not disclosed in the IRA real estate investment promoters’ materials is the prohibition of providing goods and services to your IRA. For example, if your IRA purchased a run down property to fix up and sell and you did some repairs or made arrangements for the repairs or arranged for the sale of the property, you would be providing services to your IRA, which is prohibited. If your IRA purchases a property to flip, you cannot be involved in the repairs or remodeling of the property and would have to pay someone to do all that.
Similarly, with rental properties in your IRA. If you screen tenants, collect the rent, make repairs or evict anyone, you would also be providing services to your IRA and engaging in a prohibited transaction. If your IRA purchases a rental, you can not manage the rental and your IRA would have to pay a rental manager.
Because you cannot be involved with your real estate that is in your IRA, it adds one more layer of expenses to what could already be a thin profit in these investments. By having your IRA purchasing investment real estate, you may end up taking all of the economic incentive out of it.
So what type of real estate investment would be a good choice for an IRA? One type of investment would be rental property in which your IRA purchases a share in a larger project which has other owners. The owners then would hire a manager or one of the owners to manage the project for all of the owners. In that instance, you would not be providing any services to your IRA.
Another type of investment which would be appropriate for an IRA is the purchase of raw land that requires no active management or maintenance. Your IRA would just hold the property until it is resold.
With the current IRA rules in place, you would only want to use your IRA money to invest in real estate in these or possibly other limited situations. If you invest in inappropriate real estate investments, you may end up looking at a huge tax bill which is not the result that most people would want.
If you are thinking about investing IRA money into real estate, please consult with your tax advisor before you do the investing. You want to make sure that the transaction you are contemplating would be prohibited. With the appropriate real estate investment in your IRA, you could further diversify the investments in your IRA which could make your retirement years more safe and secure.
By: Matthew M. Wallace, CPA JD
Published edited October 4, 2009 in The Times Herald nespaper, Port Huron, Michigan as: Know when to invest your IRA