Why use your IRA to acquire property
Acquiring real property from an IRA allows the IRA owner to expand the investment capability of their IRA accounts to take advantage of the twofold investment returns associated with real estate; rental income and appreciation. In addition, long term strategy can include acquiring a vacation or retirement home. In order for an IRA to acquire real property certain procedural conditions must be met, and there are several limitations on the type of properties that can be acquired. These issues include having a knowledgeable account custodian willing to handle real estate, knowing what properties can and cannot be acquired, financing acquisitions and the use and operation of the property after closing.
A Good Custodian is a must
The first issue is the capability of the IRA custodian to participate in handling the acquisition of real property. Many traditional IRA custodians, such as brokerage firms and banks are not set-up to deal directly with real estate, limiting your investment options to their offerings, usually stocks and bonds. In order to invest in real estate, you will need to find a custodian who handles these unique investments, and the options are currently limited. A Google search for “IRA real estate custodian” only yielded thirty-three hits. However, once you find an acceptable custodian who handles these real estate or self-directed IRAs, the procedure to transfer the funds from your traditional IRA custodian should not be difficult.
Types of property allowed in an IRA
The second issue is the restrictions imposed on the type and nature of the property being acquired. First, your IRA cannot acquire property that you, your spouse or other family members own. Second, you cannot live in or use the property that is acquired by the IRA, though the property can be acquired with the intention that after your retirement and disbursement, you can use the property. This use limitation would extend to leasing space in any commercial property individually or through any affiliated business. If your IRA does not has sufficient funds to make an “all cash” purchase of an appropriate property, you will have to either find partners to acquire the property, which is permitted, or finance the purchase with a lender.
Financing the purchase
However, the loan has to be non-recourse meaning no personal liability for the IRA, and you cannot guarantee the loan for the IRA. This limits the amount of financing available, and will greatly increase the loan to value ratio needed by the IRA to get financing. Generally, expect that the IRA will have to put down at least thirty to fifty percent to obtain this non-recourse, non-guaranteed financing, if available. The advantage of financing the purchase is the ability to stretch your IRA dollars to acquire a more suitable property that will both generate a positive cash flow and appreciate in value. In addition, this method is a very suitable way to acquire a retirement home at today’s lower values. Simply select a property that you wish to use at retirement, finance the purchase with the IRA providing the down payment, lease the property to cover the carrying costs to the IRA and then, when you retire, take the property in distribution of your IRA for use as a retirement home.
Pool with other investors
Another alternative is to use the IRA monies as part of a pool with third parties to invest in a fractional share of ownership, either directly or through an appropriate holding company. For example, three families with three IRAs totaling $100,000.00 can pool the money to buy a $300,000.00 investment property, with each IRA owning a 1/3rd share. It is important to have a good joint venture agreement with the other owners to insure that ownership, lease, maintenance and sale issued are addressed in advance to avoid conflict and a future lawsuit.
Leasing the IRA owned property
Once a property is acquired by an IRA, the property can be leased, and all income of leasing will flow into the IRA. However, conversely, all expenses of the property, such as taxes, insurance and maintenance expenses must be paid solely from IRA funds, meaning that the IRA mist remain liquid to cover these expenses or risk penalties associated with an early withdrawal. Another restriction is that the IRA owner can not manage the property and collect rents. Therefore, either the custodian or third party property manager will have to be retained, resulting in additional fees and costs. An alternative is to for a limited liability company (LLC) to hold title to the property and have your IRA own the membership interest (shares) in the LLC. This would allow the IRA owner to manage the property on behalf of the LLC.
Selling or keeping for retirement
Once the property is in the IRA, you are free to sell the property, with the proceeds returning to the IRA without any tax liability. These proceeds can then be used to purchase different property. Once the IRA owner reaches fifty-nine and one-half, the IRA owned property can be distributed to the IRA owner. For traditional IRAs, the distribution will result in an ordinary income tax liability based on the current value of the real property distributed to the IRA owner. However, for Roth IRA owners, no tax liability will arise, since the tax will have been previously paid. One way to avoid a huge, one time tax hit is to spread out distribution of the ownership interest over a period of years, thereby reducing the annual tax due.
A taxing issue
The one drawback to the tax liability is that the investment is not eligible for capital gains tax treatment even if the IRA holds the property for more than a year. However, upon distribution you do get to use your retirement income tax level, which will likely be lower than pre-retirement.
Using an IRA for real estate investment can provide higher returns and greater appreciation than other investment vehicles, but dangers do exist. The investment is less liquid than traditional investments, and losses can quickly mount due to lost rental income or unforeseen capital expenses that can bankrupt an IRA forcing the owner to have to fund the losses, and resulting in tax penalties to the owner. However, for the savvy real estate investor, the benefits are substantial, and can frequently make a lot of investment sense with the right property choices.
Benefits of IRA Real Estate Investment •Rental income potential •Greater long term appreciation •Portfolio diversification •Ability to leverage IRA value •Acquire future vacation or retirement asset •Tangible asset investment