Buying Real Estate Investment Property in your IRA

Is It Appropriate for You?

Christopher Rhim, CFP®, CDFA™

Asked to comment on this subject by a real estate professional and friend, I jumped at the chance to dig deep into the nuts and bolts of this alternative investment.  The research revealed two perspectives with real estate professionals (brokers, agents, banks, trust companies) on the one hand and financial advisers (certified financial planners, registered investment advisers) on the other. 

[Full Disclosure:  I am a fee-only, certified financial planner with over 20 years experience in financial planning.  I have no skin in this type of transaction:  I sell nothing, only provide advice.  I've never been a stock broker; never sold insurance; am not an attorney; do not accept any type of commission or referral fee for anything and have a fully independent, unaffiliated financial planning practice.  In this discussion, I consider myself a better-educated-than-most financial consumer.]

A synopsis of the Pros and Cons is presented first with more detailed information on the mechanics of IRA real estate investing following.

SYNOPSIS OF RESEARCH

PRO

·        This is a unique alternative to traditional investing.  Some key elements with investment real estate include rental income and distributions, capital appreciation and the ability to enjoy the benefits of tax-deferred growth. 

·        If you have an entrepreneurial spirit and are savvy about the market and investment properties, this type of investing may appeal to you. 

·        Diversify your retirement portfolio in a wide variety of assets such as condos, raw land, commercial property and more.

·        Consider this investment within a Roth IRA instead of a traditional IRA. Distributions aren’t taxed after 5 years.

·        Partner with other IRA owners to invest in multiple or larger properties.

CON

·        Managing your own self-directed IRA is more challenging than putting money in the stock market. Custodians do not vet investments and take no responsibility for downside risk.  IRA owners or their financial advisers must perform all the due diligence.

·        A primary advantage of investment real estate is the deductibility of all expenses plus capital gains tax treatment (currently 15%) when you sell.  In an IRA, none of the expenses are deductible and profits are taken at higher ordinary income rates. No depreciation deductions. 

·        You are subject to tax penalties if you need to make capital contributions to the IRA or disqualify the account. 

·        Unanticipated repairs such as roof replacement, tax assessments, systems failure, and fire damage may deplete available cash diluting your return on investment.

·        Banks charge higher rates for loans than traditional residential mortgages.  Loans must be nonrecourse (banks cannot go after other assets and the IRA owner cannot extend credit to the IRA).

·        Once required minimum distributions commence (age 70.5) you may not be able to/or want to sell the property.  It may be possible to transfer part of the IRA to yourself to meet this requirement.

·        Taxes are due on the profits of leveraged real estate (UBIT).

CONCLUSIONS

§                    This is a unique investment for a relatively sophisticated investor who has already taken full advantage of and maximized use of more traditional investment opportunities   

§                    The onus of due diligence is on the investor alone.

§                    There are significant costs of entry and exit with real estate. 

§                    Liquidity is an issue.

§                    Knowledge of the real estate market and detailed specifics of the acquisition property are prerequisites.

§                    The advice of an experienced real estate broker, attorney and CPA would be recommended prior to acquisition.

WAYS TO BUY REAL ESTATE IN YOUR IRA

USE CASH

By far the simplest way is to pay cash.  After you've identified a great investment property or piece of raw land, simply plunk down (let's say $500,000) from the IRA and it's yours!

A few caveats in this scenario:  

a)     Neither you nor any disqualified person can use it (even if you subsequently rent it).

b)    The purchase can not be from a related party.

c)     The IRA cannot be used to enable either you or a disqualified person in any prohibited transaction.

Remember, this is a retirement asset with the long-view in mind (unless you are an experienced investor with a real estate background with the intention of ‘flipping’ the property).  So, you need to think of the property's income and/or appreciation potential.  Also, this cannot be some creative way to get your in-laws beachfront property. This has to be an arms-length transaction between unrelated parties with no undue influence.  

Disqualified Persons

The law specifically prohibits transactions between disqualified persons i.e.: a spouse; parents; grandparents; children (and their spouses); any fiduciary of the IRA; any entity (like an LLC) of which at least 50% is owned by the fore mentioned; officers, directors, greater than 10% owners or highly compensated employees of the entity.

[NOTE: Disqualified person under the Internal Revenue Code does not include siblings or aunts, uncles and cousins of the IRA owner.]

PERSPECTIVE

• While cash is the cleanest way to complete this transaction, there is a higher risk level with such a large cash outlay.  Investment managers rarely allocate greater than 4-5% of their principal to any single asset.  If you already own a home, you may be greatly increasing your aggregate real estate exposure.

• Real estate tends to be a cyclical investment.  One should contemplate a “what if” scenario of an extended down period where valuations and rents/income suffers.  You need to allow for enough cash to pay for the covering costs of the property under any future circumstances.

• It should also be stated that before any purchase is contemplated, the purchase should be in a reasonable proportion to your overall retirement portfolio.  As a separate asset class, a typical total allocation to investment real estate in a well-diversified portfolio is 5-10%; higher for persons with a real estate background or experienced investors.  Under this scenario, a real estate purchase of $100,000 would be appropriate for someone with a minimum portfolio size of at least $1 million or more in other assets.

OBTAIN A MORTGAGE TO BUY REAL ESTATE

A mortgage allows you to leverage the down payment, thereby freeing up the remaining cash for other investments.  For example, using a 10%/$50,000 down payment on a home allows you to obtain a property with a value of $500,000.  That's using leverage.  

When buying investment property in your IRA, the property is collateral for the loan.  There are some restrictions which include:

a)     Minimum down payment typically 30% or more.

b)     Not all banks will finance the debt without a personal guarantee.

c)      The loan cannot be guaranteed by the IRA owner or any disqualified person.

d)     An investment that generates income with debt financing (e.g., purchasing real estate with a non-recourse loan in an IRA) is responsible for Unrelated Business Income Tax (UBIT) in direct proportion to the gain/income that's debt financed.

ü      Taxes paid must come from the IRA.

ü      These taxes are paid at Trust tax rates which are generally higher than personal tax rates.

Self Dealing


Your IRA may not buy an investment from or sell an investment to a disqualified person. This is known as self dealing.  Your IRA may not:

·        Buy property that you currently own.


·        Buy property of your parents or in-laws (lineal descent).


·        Issue a mortgage on a relative’s new residence purchased by a family member who is a disqualified person as listed above.


·        Grant a child a second mortgage for the down payment on his or her first home.


·        Buy stock from the IRA owner.

·        Purchase restricted stock from a family member.

Question: What would happen if you couldn't make the mortgage payments (i.e. you depleted your IRA)?

Ø        You can't contribute more to make the mortgage payments without tax penalties.

Ø        Possible foreclosure

OTHER WAYS TO INVEST REAL ESTATE

Form an LLC

Your IRA can co-invest with other parties by first forming an LLC that will buy a property.  The IRA can participate in the LLC formation so long as the owner and related persons own less than 50% of the LLC in aggregate. 

This set up may create some problems of self-dealing and may be deemed a prohibited transaction particularly if you have a role in any entity in which your IRA is an investor.  Consult an experienced real estate attorney to understand what you can and cannot do.

Multiple Investors – No Financing

All parties plus the IRA purchase the property.  This way, you avoid financing problems and avoid UBIT issues.  Agreement between all parties is the key to success.  Exit strategy between multiple partners is critical.

Invest in Someone Else’s Business

Avoid the hassles of investing with others.  By investing in someone else’s business and staying out of management decisions, you could receive distributions just like an annuity only without the fees.

Buy Distressed Properties

If you have knowledge of the local real estate market and how to fix up properties, you could buy select properties, renovate and resell.  You would have to work with an experienced broker who knows what to look for and have a realistic understanding of investment costs, renovation costs and a feel for how long before you could sell the property and capture a profit. 

Disclaimer: Christopher Rhim of Green View Advisors is a financial planner and does not provide tax or legal advice.  Neither he nor Green View Advisors endorses or recommends any of the aforementioned strategies, any company, or specific investments.  Any information communicated is for educational purposes only and should not be construed as tax, legal, or investment advice.  Whenever making an investment decision, please consult with your legal, tax, and accounting professionals.