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. Tax LawYou 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.AnalysisSo, 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. Closing thoughtsIt 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.--Peter
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.You might (possibly) find this thread on TMF's Ask a Foolish Question discussion board informative. Your analysis is better, but we did the best we could with the information we had.http://boards.fool.com/Message.asp?mid=16244837David Jacobs
Great research Peter. I would recommend anyone wanting a real estate investment in their qualified retirement savings to consider REITs. Less headaches on the property management side and less problems on the retirement account side - trustee, UBTI, etc.,.
It was my understanding that any real estate that goes into a 401k could not have a mortgage. Could you go into this a little?...you cannot mix money from outside an IRA with money in an IRA...And an IRA can invest in mutual funds or partnerships.So, would it be possible to have a limited partnership (the assets of which include a home or vacation property with or with out a mortgage) where shares of the limited partnership are purchased by the IRA? Is partial ownership of the LP where those funds origonated outside an IRA prohibited? Do you see where I am going with this? Could I form a limited partnership with my brother. I put in 45k in cash, my brother puts up 45k in cash we are now each 50% owners. The IRA purchases 1/3 of the corporation for $30k. (or we could also only put 30k each in and then just have the shares diluted) The corporation then purchases a 350k home with 35k down along with 15k closing costs. At this point would we be prohibited from using the property? Eventually the LP would buy the shares back from the IRA.
It was my understanding that any real estate that goes into a 401k could not have a mortgage. Could you go into this a little?Without doing additional research (it's Monday and I'm back to work), I don't think there would be any significant differences between a 401k and an IRA, unless there is something specific in IRC section 401(k) about real estate. I'm fairly sure the UBTI issues would apply equally to a 401k and an IRA. So that may be where you got your understanding. Sometimes it's easy to think you can't do something, when the reality is that you can, but you really shouldn't.As to the rest of your question - you're getting into the grey areas. The transactions between the IRA and the LP smell like they could be prohibited transactions. Specifically, they sound like buying from and selling to your IRA. It also sounds like you (and your brother - he's too close a family member) wouldn't be able to use the property.If you really wanted to do something like this, I'd heartily recommend getting a Private Letter Ruling. The consequences of being on the wrong side of the law are pretty severe.--Peter
I came to this board and thread via a post in the most recommended so I have not followed the whole thread regarding buying RE in an IRA. I have done this for years as my whole income and most of my investing is in Real Estate Limited Partnerships. I use Mid Ohio Securities to invest my IRA in RE. They can answer any questions you might have. Their web site is:http://www.mid-ohio-securities.com/I am not advertising. If you do a search under self directed IRAs I am sure you will find other options but I have used this company so I mention it. My email should be public so you can direct questions to me if you wish or ask me to come to your board if there are a lot of questions. Good luck to you allInky
Hi Inky--Can you tell us a little bit more about how your RE investing is done in your IRA? Is it all through Limited Partnerships, or does your IRA own some property directly? How about financing for directly owned property - have you done it? What was your experience?How have you handled the UBTI issues? Do you file form 990T or does the IRA custodian? Or do you even have UBTI issues?My research was strictly academic - reading the Code, Regs, and other material. I'd like to hear some real-world experiences.Thanks,--Peter
Great analysis, Peter. Very well done. You've covered virtually all of the issues. For what it's worth, while it's still kinda grey, I agree with your assesement on the tax issues on debt financed property. I can find NO trustee/lender that will grant a loan on IRA owned property without some type of personal guarantee...and as you point out, a personal guarantee will (in my opinion) trigger a prohibited transaction. For additional information on taxes in your IRA, check out my article on that very subject in the Tax Center. TMF TaxesRoy
Good analysis, but you may have missed the benefits of ROTH monies.I knew that there would be too many tax rules and interpretations to overcome for me to have my tax deferred monies "own" property. I agree with the poster who said just focus on REIT type Mutual Funds; a good, safe simple route.Back in late 2000 I felt very confident that the market was heading south (although not how much and how fast, wow!) so I researched wasy to get at my money in my ROTH IRA's. Basically, since the money in there, except the capital gains, was after tax money, I could withdraw it an not generate a taxable transaction. In addition, the tax man says that $10k can be used for "first time" home purchases. So, I took $10 from my wife's and mine ROTH acounts, put the money down on a rental property and started renting it out in 10/01.Upon filing my 2001 taxes I found no taxable situations from the withdrwal, just a taxable income from the rent and a nice offseting tax deduction for the interest on the loan and a sweet deprectiation deduction.I am fully aware of the "deferred" activities I've started and the other future tax liabilities from owning rental property, but I need, and still do need, some major deductions. My wife and I have over $60k taxable income (before the rental income) and with just the standard deduction we couldn't ge out of the tax trap. At the time we purchased the home (which by the way is in La Quinta CA, near Palm Springs; 3 bed/3 bath, 2 car garage, swimming pool, tile inside and stucco out, $176500.) I did not own the home I currently live in so I had no other deductions except my standard exemptions. We have since purchased our home here in Novato, Marin County (20 miles north of San Francisco), 3 bed/1 bath, 1 car garage (needed a new roof - fast!, new windows, needs a kithcen remodel and the hardwood floors are trash, having been flooded in the past; $385,000 - see, location is everything).For those of you who can, I would recommend getting into rental property, but only in areas where there is a good demand, nice properties for sale and sufficient rental rates to cover the mortagage. Hard to find, but I was very familiar with the Palm Springs area and know/knew that I could make it work. I hired an excellent RE Agent, presented the prospective purchases to the Leasing Agent and asked him how much he could rent them out for. It really was his knowledge of the rental market for that area that closed the purchase. If he indicated that he could not rent any of our choices for more than our mortgage, we were not going to do the deal.The Leasing Agent had a perfect tenant, signed, within 2 weeks. Well worth the 10% fee I paid ($1800). And, that's another deduction. A nice side bar is that I regularly travel to Palm Springs to visit relatives so now I can write off some of my expenses.So, as those of you have said, it seems very difficult, but possible, to have your IRA "own" a home, but I would rather have the home outside of the IRA but have used IRA monies to get it. I now have an asset that I can sell if I need to, without any IRA problems or restrictions associated with it.cat
<<Back in late 2000 I felt very confident that the market was heading south (although not how much and how fast, wow!) so I researched wasy to get at my money in my ROTH IRA's. Basically, since the money in there, except the capital gains, was after tax money, I could withdraw it an not generate a taxable transaction.>>That's basically true with respect to contributions. Conversion funds can be a little bit more tricky. But I'll assume that your research revealed the appropriate answers. << In addition, the tax man says that $10k can be used for "first time" home purchases. So, I took $10 from my wife's and mine ROTH acounts, put the money down on a rental property and started renting it out in 10/01.>>Oops...I'm not so sure that your research in this area was fruitful. The first time exclusion only applies to penalties on the distribution...not any taxes. So if you pulled out "earnings" from the Roth IRA, you could still have a little bit of a problem. Not only that, the "first time" exclusion applies only to a personal residence (one in which you live)...not to rental property. There are other requirements relative to the "first time" exclusion, but there is really no need to get into them right now. Good luck on your real estate venture. TMF TaxesRoy
Also,So, I took $10 [I think you mean 10k] from my wife's and mine ROTH acounts, put the money down on a rental property and started renting it out in 10/01...Upon filing my 2001 taxes I found no taxable situations from the withdrwal, just a taxable income from the rent and a nice offseting tax deduction for the interest on the loan and a sweet deprectiation deduction."I believe Roths have to be open for a minimum of 5 tax years to avoid the 10% penalty. I think you owe 10% of the withdrawal. The earliest you could have opened up the account is 1998.
<<I believe Roths have to be open for a minimum of 5 tax years to avoid the 10% penalty. I think you owe 10% of the withdrawal. The earliest you could have opened up the account is 1998.>>Nope...the 10% penalty is waived for "first time homebuyers" when all of the other requirements for the "first time" exclusion are met. This is true regardless of how long the Roth IRA might have been opened. The 5 tax year rule doesn't apply with respect to the penalty exception for the "first time" homeowner exclusion. But I still think that the reader has a problem trying to apply the "first time" exclusion to a rental property. :-) TMF TaxesRoy
Roy, from your article http://www.fool.com/money/allaboutiras/allaboutiras12.htmRemember that a withdrawal taken from a Roth IRA for the purchase of a first home is considered a qualified distribution after the account has been open for five tax-years.
WOW! I simply had no idea anyone cared that much about something these days. Bravo....May I now inquire as to the (1) feasibility of, (2)availability of information on, using a Roth IRA to buy drp's without !!! a broker, i.e., depositing $3500 (over 50) in a bank account (trustee) and sending periodic payments to Companies with DRP's ???In relation to (2), I have looked thru FAQ's and backtracked, but as someone said once, "When you're looking for a needle in a haystack, what you don't need is more hay"Thanks for your insight
<<Remember that a withdrawal taken from a Roth IRA for the purchase of a first home is considered a qualified distribution after the account has been open for five tax-years. >>True...but don't forget to post the rest of the paragraph...<<As such, any distribution taken from a Roth for that purpose and under those conditions will be both income tax- and penalty-free.>>So...what I was TRYING to say with such a badly written paragraph is that if you meet the five year rule, you might just have a QUALIFIED distribution...not only penalty free, but also tax free. Thanks for the help...TMF TaxesRoy
<<May I now inquire as to the (1) feasibility of, (2)availability of information on, using a Roth IRA to buy drp's without !!! a broker, i.e., depositing $3500 (over 50) in a bank account (trustee) and sending periodic payments to Companies with DRP's ???>>You'll likely not find any companies that will participate with DRIPs into an IRA account...Roth or Traditional. Too much paperwork for them (the company) to complete when you take distributions. I don't know of any company that will provide a DRIP to an IRA. If anybody knows of one, then feel free to spread the word. <<In relation to (2), I have looked thru FAQ's and backtracked, but as someone said once, "When you're looking for a needle in a haystack, what you don't need is more hay">>As I say...I don't know if you'll find any companies that will DRIP into an IRA. But feel free to give it your best shot. TMF TaxesRoy
You'll likely not find any companies that will participate with DRIPs into an IRA account...Roth or Traditional. Too much paperwork for them (the company) to complete when you take distributions. I don't know of any company that will provide a DRIP to an IRA. If anybody knows of one, then feel free to spread the word.How about these? (Or isn't this what is asked about?) http://www3.netstockdirect.com/nsdasp/DetailLevel1.asp?NoGraphics= Isn't the idea that the owner of the IRA makes cash contributions and then the cash is used to make stock purchases? Then, when (qualified)distributions are taken, what comes out of a traditional IRA is going to be taxed as regular income, and what comes out of a Roth is not going to be taxed at all, so I really don't see what the paperwork would involve... I must be missing something....--SirTas
Thank you both for the support of an idea that continues to haunt me. I don't know if it's good or bad?To simplify this more, it seems that the ROTH IRA's tax liabilities involve 2 items, (1) maximum per year contributions, and (2) a five year holding period.If an account could be established to verify the per year contributions and the five year holding period, then any gains from investments would be free of tax consequences, and I should think, paperwork.Is the Gov't asking for more verification or supporting documents from my No fee IRA discount brokerage account? They don't get much for whatever they're required to provide, other than another drop in the pond of poolable suckers to buy and sell their crappy stocks to, oops, I've revealed too much, as usualHappy trails to Roy Rogers and Sir Tas
Inkwell, are you still around?Back in '02 you posted that you were actively engaged in real estate investing in an IRA using Mid-ohio Securities as a custodian.May we have an update? How is it going? Is the IRA working out? Any new hassles are developments?Please keep us advised.Thanks.
Inkwell, are you still around?Per 'Profile', Inkwell's last post was... Date: 8/27/02 5:02 PM
Thanks, geocar. I noticed that. I'm hoping the e-mail will still get through.I notice the link to Mid-Ohio Securities in his posting is also dead.
The Mid Ohio Securities url has changed to:www.midoh.comActually, there is a link on that site to one that seems to specailize in unusual investments (like RE) in IRAs:www.trustetc.com.GM
Thanks for the update, Gary.
Thanks, Peter. I'd heard conflicting opinions about who you could rent the property too. In my case, I have enough accumulation to purchase the property outright. I was hoping to use the IRA to purchase retirement homes for both my elderly mother and disabled vet brother. Thanks again for the info.
Yikes!!!Threads need to die at some point.The content of a thread could be restarted in a new thread.Just saing,Hohum
Threads need to die at some point.<grinning>Not at TMF. Threads are forever. I think you can still read and reply to 1997 or 1998 posts if you like.</grinning>The content of a thread could be restarted in a new thread.Actually, it was. He asked a question on another board and I directed him to that aging post, as it is still quite relevant. Just saing,HohumJust saying, --Peter
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