I haven’t discussed IRA real estate investments in a while. I have received a number of inquiries regarding these investments within the last few months. So, I have decided to revisit this topic and update the information for you. With interest rates at historic lows and returns on stock funds not stellar, you are probably looking for investments with better returns. With real estate currently bargained priced, investment in real estate looks attractive. But what is the best way to use IRA funds to invest in real estate?
You could just take the funds out of your IRA to purchase the real estate. However, this is a taxable withdrawal 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. Wouldn’t it be better to have your IRA to purchase the property directly, so you do not have to pay the income taxes or penalties now?
Most financial institutions have an internal rule that only financial securities such as stocks, bonds and cash are allowable investments in an IRA. There are certain investments that are not allowed 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 and bullion coins are not considered prohibited investments.
In addition, under the federal rules, real estate is not considered a prohibited investment. Your first challenge is to locate a financial institution that is willing to allow a real estate investment in your IRA. Get a referral from someone who is doing it or check online.
You must be careful when investing IRA funds in real estate. Often IRA real estate investment promoters 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 loan.
- You can not receive goods or services from or provide goods or services to your IRA.
If you or a disqualified person engage in any of these or other prohibited transactions, your entire IRA is deemed to be distributed to you on the first day of the tax year of the transaction. A disqualified person includes any of your ancestors or descendants. Interestingly, a sibling, niece, nephew, aunt or uncle is not considered a disqualified person. In the event of a prohibited transaction, income taxes would not only have to be paid 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. You can not manage the rental owned by your IRA. Your IRA would have to hire a rental manager. This adds one more layer of expenses to what could already be a thin profit margin in these investments.
To beef up the profit margin, you could have your IRA purchase the real estate using borrowed funds. However since your IRA assets cannot be security for a loan, traditional land contracts or mortgage loans cannot be used by your IRA to purchase the real estate Your IRA would have to use non-recourse land contracts or mortgage loans.
With non-recourse debt, the lender can only go after the real estate in the event of a default, not after an individual or the other assets in your IRA. With our current economic conditions, few banks or other financial institutions are willing to offer non-recourse loans. And if they do, they may require a substantial down payment, such as 50% or more. The most likely non-recourse debt is seller financing.
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 such as a shopping center or apartment complex, which has other owners. The owners then would hire a manager or one of the other 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 your IRA money into real estate, please consult with your tax advisor before taking the plunge. You want to make sure that the transaction you are contemplating would not 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 August 19, 2012 in The Times Herald newspaper, Port Huron, Michigan as: Real estate in IRAs