For so many, retirement account assets comprise the bulk of their savings. As a result, there is always interest in understanding options for investments using those retirement funds. There are many traditional investment options such as real estate investment trusts, mutual funds, ETFs, bonds and stock for publicly traded companies. Recently though there has been an increased interest in real properties such as rental properties as an investment option within an IRA. As a result, I wanted to provide some information on items that should be considered when thinking about purchasing real estate in an IRA:
Prohibited Transactions – The IRS maintains strict guidelines on what is considered a prohibited transaction within an IRA.
- You may not borrow money from your IRA – Some have heard that you can borrow money from your retirement. This is partially true. While you are able to borrow money from a 401K plan if the plan allows it, you are not able to borrow from an IRA. In a 401K plan, you can borrow up to 50% of the balance of the account or $50,000 whichever is less.
- Sell property to the IRA – you and any member of your family are not allowed to engage in a transaction to sell property to the IRA.
- Secure a loan with it – you cannot use an IRA as a form of collateral for a loan.
- Purchase property for personal use – while purchasing real estate and other forms of property is allowed, the property cannot be intended for personal use. For example, you cannot purchase a vacation home with an IRA, as the purpose of the property would be for your family to use on vacation. You could however purchase an investment property.
Leveraged Purchase – The best option is to have a large enough balance for a cash purchase. I say this because while lending options are available the prevailing rates and fees are going to be higher than traditional mortgages. Why? Lending to an IRA is a very specialized loan. These loans are riskier for the banks because there is no recourse other than the property used for collateral. The loan is made directly to the IRA, and the beneficiary of the IRA is not at risk personally. As a result of the increased risk, these loans have higher down payment requirements. In some instances, the lender may require as much as 50% of the value of the property. The lenders might also require a reserve in the IRA to cover the mortgage payment if the property is vacant for a period of time.
Custody – In a traditional purchase, the property is deeded to you or a business as the owner. Because the purchase of the real estate is made within an IRA, the formal deeded owner of the property is the IRA. As a result a custodian must be willing to hold the real estate property as an asset within the IRA for your benefit. Because IRAs have specific IRS rules as a retirement plan, a custodian is required to track all the activities of the IRA. The custodian has a responsibility to report or track activities such as contributions and distributions. The problem with a real estate purchase in an IRA is that traditional institutions such as Charles Schwab or Fidelity will not take responsibility for the tracking and providing the services necessary to facilitate the transaction. The good news is that there are custodians that will hold these assets, but you will want to research them carefully before choosing one to use. In my research, I found both Equity Trust and Millennium Trust will provide the services for real estate purchases.
Taxes – In a traditional real estate investment, depreciation on the property’s structure is a great benefit. The depreciation offers a deduction on your taxes to reduce your tax burden given the income stream generated by the investment property. Because the IRA is tax sheltered and is the owner of the asset, there is no tax benefit for depreciating the asset. Fortunately, this also works in your favor. Any cash flow generated from the property is paid directly to the IRA and not taxed as income. Taxes will be paid in the future when distributions are done from the IRA.
Another tax consideration is unrelated business income. According to the IRS, an activity is identified as Unrelated Business Income if it meets three requirements.
- It is a trade or business,
- It is regularly carried on, and
- It is not substantially related to furthering the exempt purpose of the organization.
The IRS does identify certain activities that are exceptions to this rule. Specifically, rental income and gains or losses from the disposition of property are listed as excluded activities.
Maintenance and Improvements – Since the property is formally owned by the IRA, all maintenance and improvements need to be made with capital available in the IRA. It is important to maintain a cash reserve to insure that immediate maintenance needs can be addressed. Since there is an annual contribution limit imposed for IRAs, you are not able to quickly add capital for use to maintain the property. Planning for unseen events is critical.
While real property is a potential option for investing in your IRA, you should carefully consider all the implications. The goal of these considerations is to begin the process of thinking through what should be addressed, but it does encompass all aspects that must be reviewed. I highly recommend seeking guidance from a professional for your personal situation before making an investment that potentially risks the tax exempt status of the entire IRA.
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