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Beware of Using Your IRA to Buy Real Estate
Clifton Gunderson
Stocks bonds, and mutual funds seem to be the most common assets to hold in individual retirement accounts (IRAs). However, with the current hot real estate market, more individuals are seeking to earn higher returns by adding real estate to their IRA portfolios. Although it may sound enticing, there are significant obstacles to holding real estate in an IRA.
Self-Directed IRAs First, most typical IRA custodians limit investments to marketable securities and cash; thus, in order to hold real estate in an IRA, individuals usually must open self-directed IRAs. A self-directed IRA usually contains language that allows the IRA owners to direct the custodian to make any investment permitted by law. Permitted IRA investments include properly structured acquisitions of real estate (including undeveloped land, rental properties, and commercial properties). The real estate can be owned directly or indirectly through an ownership interest in an LLC, =partnership or a corporation.
Watch Out For Prohibited Transactions IRA owner involvement via a self-directed IRA greatly increases the risk of a prohibited transaction occurring.
The Internal Revenue Code prohibits certain types of transaction between an IRA and a “disqualified person,” which includes the IRA owner and his or her beneficiaries. The following transactions between the IRA and IRA owner (and/or the IRA’s beneficiaries) are considered prohibited transactions:
The sale, exchange, or leasing of any property.
The lending of money or other extension of credit.
The furnishing of goods, services, or facilities.
The transfer of the IRA’s income or assets to, or use by or for the benefit of, the disqualified person.
An act by disqualified persons who are fiduciaries whereby the deal with the income or assets of an IRA in their own interest or for their own account.
The receipt of any consideration for the personal account of a disqualified person who is a fiduciary from any party dealing with the IRA in connection with a transaction involving the income or assets of the IRA. It is important to note that you cannot use your IRA in a way that would enable you to make an investment that you otherwise would not be able to make. If an investment by your IRA is deemed essential to permitting you to make an investment in the deal, the transaction will be a prohibited transaction.
In addition, you could not occupy any real estate owned by your IRA. As a result, you cannot have your IRA buy a vacation home that you use two weeks a year, even if you rent the property to third parties during the rest of the year.
If the IRA owner or beneficiary commits a prohibited transaction, the account ceases to be an IRA as of the first day of the tax year. This results in the fair market value (FMV) of all assets held by the IRA (as of the first day of the year in which the prohibited transaction occurred) to be treated as distributed to the owner on the first day of the year. These deemed distributions will be taxable as ordinary income to the IRA owner and also may be subject to the 10 percent penalty on early withdrawals.
Lost Capital Gains Rates. Taxable distributions from a traditional IRA are 100 percent ordinary income, even when the underlying transaction, such as the sale of land, generates capital gain if held outside of the IRA. With a traditional IRA, if the value of the deferred recognition of the real estate’s income is not sufficient to offset the gap between capital gain and regular income tax rates, it probably isn’t a good idea to hold the real estate in a traditional IRA. Unrelated Business Taxable Income (UBTI) Trapincludes income from a trade or business regularly carried on by an IRA, which is not substantially related to its tax-exempt purpose. Generally, dividends, interest, annuities, royalties, most rents from real property, and gains and losses from the sale of property are excluded from UBTI; nonetheless, income your IRA earns on leveraged property will be considered UBTI. This type of income is called, debt financed income and is taxed at individual tax rate that are more steeply graduated. To add insult to injury, the tax must be paid by your IRA.
The custodian or trustee of an IRA must be a financial institution (i.e. bank); however, most banks refuse to allow any IRAs for which they are custodian or trustee to hold title to anything other than marketable securities and cash in an IRA, which makes it difficult to find a custodian for a self-directed IRA investing in real estate.
When a custodian who will hold title to the real estate in the IRA is found, a system will have to be implemented for paying expenses and receiving income that does not involve the IRA owner. The system is needed because once the real estate is in the IRA, the IRA owner cannot pay real estate-related expenses or receive rents without making a deemed contribution or receiving a deemed distribution from the IRA. Without such a system, the IRA could potentially be disqualified for engaging in prohibited transactions.
The custodian also must be willing to receive income from the real estate and pay real estate-related expenses directly from the IRA. However, if the IRA does not yield a positive cash flow, and the IRA owner must fill the void with personal funds in excess of the allowable IRA contribution limits, an excess contribution will result.
Fix It Up Flukes.
If IRA owners expend their own time and labor improving the real estate owned by their IRA, they may be found to have made an excess contribution to the IRA that is subject to the excess contribution penalty tax. In addition, if the IRA profits from the owner’s personal services, this could result in an improper assignment of income (from the owner to the IRA). The IRA also could be disqualified if the IRS treats the owner’s actions on behalf of the IRA (i.e. his or her fix it up services) as a prohibited transaction.
Proceed with Caution.
Although it may be possible to successfully hold real estate in your IRA, we do not recommend that you do so unless you obtain very good legal and tax advice. One misstep and you risk a very significant tax bill and quite possibly, the complete disqualification of your IRA. The benefits of funding a real estate purchase with IRA money (tax free accumulations of earnings and access to a stash of cash) may not be sufficient to offset the risks that you will run afoul of the prohibited transaction rules or generate UBTI.
Clifton Gunderson LLP
301 SW
Adams, Suite 600
Peoria, Illinois 61602
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