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A little-known IRS provision lets you extend
your real estate purchasing with tax-deferred dollars.
(BY KELLI L. CLICK)
Are stock market woes preventing you from
building wealth in your retirement account? If so, you might be interested in a
small, but growing, trend among individual retirement account
owners—investing their retirement funds in real estate.
How It Works
If the option of using
tax-deferred funds to purchase property sounds appealing, you’ll need to
locate an independent IRA custodian that allows real estate investments and
work with that company to set up an IRA account. Most banks and brokerage
companies—the most common IRA account options—limit your choices to
certificates of deposit, stocks, mutual funds, annuities, and similar financial
instruments. But Section 408 of the Internal Revenue Code permits individuals
to purchase land, commercial property, condominiums, residential property,
trust deeds, or real estate contracts with funds held in many common forms of
IRAs, including a traditional IRA, a Roth IRA , and a Simplified Employee
Pension plan, or SEP-IRA.
To find a custodian that specializes in real
estate, search under terms such as “real estate IRA” or
“self-directed IRA.” This latter term was coined by the financial
industry in the 1980s to distinguish the self-directed IRA from other IRAs that
focus on stocks and bonds. The IRA account holder can’t serve as the
custodian of his or her own account. However, it’s important to select a
custodian knowledgeable about the types of investment you’re interested
in, because the custodian holds title to the real estate. Do your homework, and
understand what you’re getting into.
Fees can vary widely among custodians, as can
the flexibility of the services provided for account holders. If the custodian
holds real estate on your behalf, but does not service it (collect the rent,
etc.), you may have to contract with other providers. However, be sure that all
rents are paid into the IRA and that all taxes are paid by the IRA.
Purchasing the Property
Most IRA
custodians that hold real estate will usually allow you to purchase raw or
vacant land, residential properties, or commercial buildings for your
portfolio. In addition, some custodians may permit foreign property or
leveraged property.
Since buying a property may require more funds
than you currently have available in your IRA, you also can have your IRA
purchase an interest in the property in conjunction with other individuals,
such as a spouse, business associate, or friend. Also keep in mind that if the
property is leveraged, the debt must be a non-recourse promissory note.
Unfortunately, Internal Revenue Service
regulations will not let you use the real estate owned by your IRA as your
residence or vacation home. Nor can your business lease space in your IRA-held
property. The underlying premise for any real estate investment purchased with
IRA funds is that you can’t have any personal use or benefit of the
property. To do so may cost you plenty in taxes and penalties.
There are a few other IRS limitations as well.
You cannot place a real estate property that you already own into your IRA.
Your spouse, your parents, or your children also couldn’t have owned the
property before it was purchased by your IRA. Property owned by siblings may be
allowed, since the Internal Revenue Code (section 4975) specifies that only
“lineal descendents” be disqualified.
Once you’ve chosen a property, your IRA
custodian—not you personally—must actually purchase it. The title
will reflect the name of your IRA custodian for your benefit (such as Silver
Trust Co., Custodian FBO John Doe IRA). In addition, if you put up earnest
money with your personal funds, you’ll need to make sure you include that
amount in the total due so that the title company can reimburse you upon
closing.
Operating an IRA-held
Property
Because all property expenses, including taxes, insurance, and
repairs, must be paid from funds in your IRA, you’ll need liquid funds
available in your account. Of course, all income generated from the property
will be deposited in your IRA account so you can use that money to cover your
costs. You also can make annual contributions within federal guidelines.
Currently, you can contribute $3,000 annually to a traditional or Roth IRA
($3,500 if you’re age 50 or older) and as much as 15 percent of your
annual compensation, up to $40,000, if you’re a self-employed individual
with a SEP-IRA. If your account doesn’t have funds to cover property
expenses, you will have to withdraw the property from your IRA and pay taxes on
the value of the property, as well as possible penalties for early
withdrawal.
It’s also possible to sell properties
while they are held by your IRA, so long as the purchaser is not a family
member. Once a deal closes, your IRA account now holds the cash
proceeds—ready for you to make your next investment. An alternative is to
sell an IRA-held property with seller financing so that all payments made by
the buyers are paid to the IRA.
Distributing Your Property
You can
withdraw real estate from your IRA and use it as a residence or second home
when you reach retirement age (age 59½ or older for a penalty-free
withdrawal). At that time, you can elect either to have the IRA sell the
property or take an in-kind distribution of the property. Under that
arrangement, your IRA custodian assigns the title to the property to you. You
will then have to pay income taxes on the current value of the property if
it’s been held in a traditional IRA. If the property was held in a Roth
IRA, you won’t owe taxes at distribution. This makes a Roth IRA extremely
attractive if you anticipate that your real estate investments will appreciate
over time.
Whether your retirement strategy is to hold
properties or buy and sell for gain, real estate investing through your IRA can
yield extraordinary returns toward your future retirement.
IRA Options
While any form of IRA
allows for real estate investment, there are other pluses and minuses to
consider when choosing the account type that’s best for you:
- A traditional IRA lets
you deduct annual contributions (currently set at $3,000, or $3,500 if
you’re age 50 or older) from your income. However, once you begin
withdrawing money, those funds will be taxed as regular income.
- A Roth IRA gives you no
deduction on your current contributions (again $3,000), but does allow you to
withdraw funds tax-free. If you expect to buy a real estate investment in an
IRA and hold it for a long period, this is probably your best option,
particularly if the property increases in value over that period.
- A SEP-IRA is designed
for self-employed individuals and small companies. You can contribute up to 25
percent of your compensation, or $40,000, whichever is less. However, keep in
mind that if you have employees, you must make contributions for them as well.
This option is a great alternative for real estate practitioners who can make
the higher contributions because they can build up funds more rapidly to
purchase properties. Withdrawals from a SEP-IRA are treated like those of a
traditional IRA for tax purposes.
Kelli L. Click is vice
president of sales and marketing at Sterling Trust Co., a self-directed IRA and
401(k) custodian, in Waco, Texas. She can be reached at 800/955-3434, ext.
250.
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