Real Estate As An Individual Retirement Account Investment
If you think the stock market is overvalued, you’ve been disheartened by the relatively low rates of return offered by your traditional fixed income investments or you need to diversify your retirement portfolio, you can open a self-directed Individual Retirement Account (IRA) that invests in real estate.
The rules are very strict about what you can and can’t do in a self-directed IRA.
- Your IRA must own the real estate strictly as an investment, which means no use by you or certain family members.
- The IRA trustee must hold legal title to the property.
- Your IRA (not you) must have sufficient liquid assets (either from other investments in the account or from your annual contributions) to cover the costs of owning and operating the real estate.
Remember: You lose some tax advantages by holding real estate in a traditional IRA, SEP IRA or SIMPLE IRA.
Specifically, you won’t benefit from the lower capital gains rate on long-term real estate gains and you can’t claim current deductions for mortgage interest, property taxes, depreciation and so forth that you’d typically write off on your federal taxes.
However, if you use a Roth IRA to invest in real estate, the property can be sold with the gain eventually distributed federal-income-tax-free (and maybe state-income-tax-free, too) to you or your heirs, as long as you follow the rules for tax-free Roth IRA distributions.
Buying a rental property with cash and setting aside cash in a money market reserve fund are potentially good choice for IRAs. Real estate mutual funds and REITs (real estate investment trusts) are other real estate related investments for your IRA funds.
A rental property you buy with a mortgage is less advisable, because it potentially creates Unrelated Business Taxable Income (UBTI) and a resulting federal income tax bill for your IRA. UBTI is essentially a tax on the business income your IRA makes. However, you can use mortgage interest, repairs and other property expenses to minimize the profit the property earns.
Bottom line: your IRA must have enough liquidity (rents plus your reserve account) to pay the mortgage, plus other property expenses related to the property and pay any UBTI tax bills.
If you buy a property for your IRA with a mortgage, the debt must be in the name of the IRA trustee and not in your name. Also, you cannot be personally liable for mortgages against property owned by your IRA.
Bottom line: Consult with your tax adviser before using your IRA to invest in mortgaged real estate or a real estate partnership. You want to make sure the investment won’t create UBTI problems. For a large transaction, ask your tax adviser about getting a government ruling on this issue.
Avoid Prohibited Transactions
You must also avoid doing anything in your real estate IRA that breaks the rules on self-dealing – using the IRA account for your own benefit.
Do that and you could owe hefty taxes and penalties.
The types of transactions that could cause you to run afoul of the rules:
- Leasing the real estate to yourself or a family member.
- Taking out a personal loan secured by the real estate.
- Buying or selling the real estate to related parties or family members.
Interested in buying investment real estate? Call or email me and we’ll discuss your options.
Tax laws and tax rules are constantly being updated and interpreted. This article contains general information, so please discuss your individual situation with a trusted tax adviser before making tax decisions.
