One of the frequent questions I am asked by my clients is whether or not they can use their IRA money to purchase real estate. The answer is always yes, but with a big pause. The reason? Owning real estate inside your IRA is potentially a recipe for disaster.
The rules are so restrictive that it is easy to trip up over one of those rules and find yourself saddled with income taxes and penalties that ravage your IRA and render it useless for retirement. Still, there are many success stories out there and doing it correctly can mean a significant savings in taxes both during your accumulation phase (pre-retirement) and distribution phase (retirement).
Let’s take a look at some of the rules.
Section 408 of the Internal Revenue Code permits individuals to purchase real property using their IRA funds. Almost any type of real estate may be purchased other than a principle residence or a vacation home.
- Examples of real estate that may be owned by an IRA include:
- Commercial Property
- Residential Property
- Trust Deeds and
- Real Estate Contracts
- The following IRAs may own real estate:
- Traditional IRAs
- Roth IRAs
- Simplified employee Pension Plans and
- Specific Rules to Follow:
- The IRA account holder cannot also be the Custodian of the IRA
- The IRA Custodian holds title to the real estate owned by the IRA
- Your IRA may purchase an interest in real property (i.e. it may be a partner)
- All debt on the real property must be nonrecourse (meaning: no personal guarantees)
- You cannot lease space from your IRA-held property
- You cannot personally use the IRA-held property
- You cannot place real estate you or your lineal descendants (spouse, parents or children) own into the IRA
- All property expenses (including repairs) must be paid from the funds in your IRA. Thus, your IRA must have some liquid cash reserves.
- All income generated from the property must be deposited into your IRA
- You can sell real property that is owned by your IRA without any tax consequences
- You can never engage in any related-party transactions with the IRA. Never means never
- You cannot manage the property owned by the IRA
- The best way to find IRA-Real Estate Custodians is to search the Internet for “real estate IRA” or “self-directed IRA”. Here are some Custodians who popped up on my search:
- Entrust Administration
- Pension Trust Company
- Asset Exchange Strategies
- Equity Trust Company
- Truly Self Directed IRAs
- Sunwest Trust Inc.
- Guidant Financial Group
Pluses and Minuses:
Plus: You can distribute property owned by your IRA, penalty-free, once you reach age 59 1/2. If the IRA is a traditional IRA, you will pay income tax on the fair market value of the property you receive. If your IRA is a Roth IRA there are no tax consequences on the distribution. This makes Roth IRAs a very attractive vehicle for owning real property, since the appreciation is never subject to any income tax.
Minus: Owning real property inside your IRA means you forfeit the traditional tax advantages associated with investing in real estate. This includes deductions for real property taxes, mortgage interest, depreciation and capital gains treatment. Many small real estate investors also take advantage of the $25,000 passive activity loss exception, which allows a tax deduction up to $25,000 for losses incurred in owning rental properties. This exception reduces regular income tax and is a significant tax benefit, year in and year out.
Before you make any decisions regarding using an IRA as a vehicle for real estate investing consult with your tax advisor or a tax attorney for complete details regarding your specific tax needs.
Tom Corley is an accountant, financial planner and author of “Rich Kids: How to Raise Our Children to Be Happy and Successful in Life”, “Effort-Less Wealth”, “Change Your Habits Change Your Life”, “Rich Habits Poor Habits” and “Rich Habits: The Daily Success Habits of Wealthy Individuals.”