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Financial Planning / Tax Strategies
|Subject: Buying Real Estate in an IRA||Date: 7/28/2002 10:25 PM|
|Author: ptheland||Number: 61025 of 124815|
Using IRA money to invest in real estate has been a recurring topic here at the Fool that never seems to get a very definitive answer. Being a tax guy, I thought I'd take a few spare minutes and research the issue. Well, it took more than just a few minutes. And although I was focusing on IRA accounts (both traditional and Roth) it seems that this is also equally applicable to other retirement accounts that a self-employed person might have – SEP's, SIMPLE's, Keogh's, money purchase, profit-sharing, and defined benefit plans.
First off, let's take a look at a few of the specifics of an IRA.
You need a trustee for an IRA. According to IRC section 408(a)(2) the trustee must be a bank (the nitty gritty details include credit unions and S&L's) or an “entity approved by the IRS to act as trustee or custodian.” There's a whole host of rules on what these entities can be, but basically it's got to be an organization that can handle the record keeping and reporting required by a bunch of IRA accounts. Individuals are specifically excluded from being an IRA trustee. You'll commonly find mutual funds and security brokers as qualified trustees, but any organization who can convince the IRS of their experience and skills can be approved as a trustee.
IRC section 408(a)(1) stipulates that contributions to an IRA must be in cash. But a rollover from another IRA or qualified retirement plan can be either in cash or in securities. Contributions are limited to $3000 per year ($3500 if you're over 50) for 2002, increasing to $5000 over the next few years.
IRC section 408(a)(5) says that an IRA trustee cannot commingle funds, except for a “common trust fund” or “common investment fund.” Basically, this means that you cannot mix money from outside an IRA with money in an IRA. However, a group of IRA's can get together to make common investments. And an IRA can invest in mutual funds or partnerships.
There isn't a list of acceptable investments for an IRA, but there is a list of unacceptable investments in IRC section 408(m). The list includes works of art, coins, gems, and antiques, but not real estate. There are also some transactions that are specifically prohibited by IRC section 4975. You can't sell anything to your IRA, you can't perform services for your IRA, you can't use your IRA as security for a loan, and your IRA can't buy property for your personal use. There are some other prohibited transactions, but these are the ones of interest to this subject.
Organizations exempt from income tax can still be subject to income tax if they have Unrelated Business Taxable Income (or UBTI). UBTI is discussed in code sections 511 through 514. An IRA is an organization exempt from income tax. And there is a Private Letter Ruling (PLR 9703026) that goes into this issue for an IRA. PLR's apply only to the taxpayer that asked for the ruling, but they still give you an insight to the general thinking of the IRS. In this particular case, the IRA was subject to UBTI because of its debt-financed real estate activities.
So, what can we conclude from these IRA rules? The major one is that real estate is a perfectly acceptable investment for an IRA. You just have to overcome a couple of administrative and operational issues to own real estate in your IRA.
The first issue is finding a trustee to hold the real estate. Banks are willing to be trustees, because they want you to put your money in a savings account or CD. Then they loan that money out to others and profit on the difference in interest rates. Brokers are willing to be trustees, because they make money when you buy and sell stocks or bonds. Mutual funds are willing to be trustees, because you put your money in their funds and increase their assets under management, increasing their management fees. But none of these businesses want to hold real estate for you. Real estate doesn't make them money the way they want to make it. So you've got to find a trustee willing to hold real estate. I have no experience or recommendations for you. But I did type “IRA trustee real estate” into a Google search and turned up several willing trustees. So they are out there, they just take a little more work to find and research.
Another issue is the details of purchasing real estate in an IRA. It's pretty hard to find a good rental property to buy with your $3000 annual contribution. You can't sell a partial interest in a property to your IRA – that's a prohibited transaction. Neither can you contribute $3000 of equity in an existing property – IRA contributions must be in cash. Both of these would also result in IRA funds being commingled with your non-IRA assets. You couldn't jointly own a property with your IRA. But your IRA could jointly own a property with your spouse's IRA (and your neighbor's or co-worker's IRAs if you wanted to). You could accumulate several years of contributions until you've got enough put together to buy a property. Another source of sufficient money could be a rollover from your retirement plan at work. Or you could finance the property.
Financing raises more issues. Finding a lender is one. You'll need someone who will lend to the IRA (NOT you – you're not buying the property). I'm not sure if your personal guarantee of a loan is a prohibited transaction or not. But if you were ever called to make good on a guarantee, you'd likely run afoul of a prohibited transaction or an excess contribution (or both). You've also got to make sure you have adequate cash flow for the financed property. You can only add $3000 per year to your IRA (although that amount is increasing to $5000 over the next few years), so you can't have very much of a negative cash flow. This is a real issue if you ever have a vacancy while holding just one single family residence. You'll need to keep some reserves on hand to cover this possibility.
But the biggest problem with financing a property is that it raises UBTI issues. Rents from real estate are specifically excluded from UBTI unless the property is debt-financed. This is where things get a bit muddy. The PLR I quoted above indicates that debt-financed property in an IRA is subject to UBTI. After reading through the law and the regs, I agree with their finding. So if your financed real estate generates net income, your IRA will pay tax on that income! That's not necessarily a major problem since depreciation is an allowable expense and could easily make the net income for this purpose zero or a loss. The bigger issue – and one that's not addressed in the PLR – is if a gain on the sale of debt-financed real estate is also subject to UBTI. Regulations Section 1.514(a)-1 (a)(1)(v) specifically includes gain on the sale or disposition of debt-financed property in UBTI. The result – selling debt-financed property for a gain would result in a taxable gain to your IRA. That would defeat the major purpose of holding any asset in an IRA – tax deferral. And to make matters worse, the net proceeds (after this tax) are still in an IRA. So with a traditional IRA (but not a Roth) you'll pay tax yet again on what's left when you withdraw the funds from the IRA.
Leaving the debt-financing aside, let's look at some final operational issues. Who can rent the property once you've acquired it? You can't, and neither can much of your family. You'll have to rent the property to third parties. How about repairs and maintenance? Providing services to your IRA is a prohibited transaction, so you'll have to hire someone to do those things for you. How about management? That doesn't seem to be as cut and dried. This would be a self-directed IRA, so a certain level of management is expected. Selecting a property to buy or sell would be fine, as would decisions regarding capital improvements – room additions, remodeling, and the like. I didn't find any clear direction in the code or regs on the more mundane management aspects – collecting rents and paying expenses, calling a plumber in the middle of the night, things like that. The web sites I perused all seemed to lean towards hiring a management company. But then again, they want to be that management company, so their advice doesn't sound entirely impartial to me.
It seems that owning real estate in your IRA is quite possible as long as you keep aware of certain issues surrounding the investment. However, I haven't addressed the issue of why you would want to use IRA money to invest in real estate. The pat answer is to take advantage of the tax deferral or, in the case of a Roth, the tax-free withdrawals. This is a weak answer, in my opinion. In a traditional IRA, income is deferred until the money is taken out of the account. At that point it becomes ordinary income. Capital gains that happen inside an IRA lose their character and become ordinary. Because of this, there is a line of reasoning for IRA's that suggests owning income producing assets (like bonds and high dividend stocks and mutual funds) in your IRA. Long term investments in stocks that don't pay a dividend can be held outside your IRA with no tax consequences until you sell. When you do sell, the gain is taxed at the favorable capital gain rates.
The same issues would apply to owning real estate. Aside from the UBTI issues, debt-financed property often runs near a break-even point or even at a loss for tax purposes because of the depreciation allowed. So there is little current taxation, and sometimes a tax shelter, from owning real estate. In this situation, the economic gain is expected to be from appreciation in the property over the years. By putting this kind of real estate in an IRA, you lose any potential tax shelter from operating losses, and convert the capital gains into ordinary income. Of course, withdrawals from a Roth IRA aren't subject to taxation at all, so the argument loses some steam when applied to a Roth. Outside of an IRA the same general result (of tax deferral) can be accomplished through the use of 1031 exchanges without sacrificing the favorable capital gain taxation.
However, owning a property free and clear in your IRA makes more sense to me. You shelter current income at the cost of converting capital gain into ordinary income. Plus, you're free of the UBTI nightmare scenarios. For someone with a significant accumulation in an IRA, it could also be a way to acquire what would ultimately be a retirement property. Your IRA can buy the property now, rent it out until you retire, then distribute the property to you sometime in the future. The FMV of the property would be taxable to you at the time of distribution.
My bottom line: like many other things in life, putting real estate in an IRA is possible, but it's not for everyone. In the right circumstances, it could make a lot of sense. In the wrong circumstances, it could add significant unnecessary taxes to your life. You'll have to analyze your own situation to see if it makes sense for you. Hopefully, this information will help you with that analysis.
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