Buying Real Estate In an IRA
Every now and then someone will ask me whether they can buy real estate in an IRA. The short answer is “yes”. But, the long answer might convince you not to.
First of all, investing IRA funds in real estate means that it must be a cash transaction where the IRA owns 100% of the asset (Unless it is in a REIT, TIC or something like that, but then you lose control). The real estate must be titled in the name of the IRA and the IRA most likely cannot get a loan from a bank. In addition, you cannot sign a personal guarantee for the real estate that is owned inside the IRA. There are IRA rules against that. So, in essence, it must be all cash. This rule alone eliminates a large amount of potential investors and properties.
But, let’s say that you do have a rather large amount of cash in an IRA and you want to invest it in real estate. If it is a Traditional IRA or an IRA Rollover I would strongly advise against it. Why? Because, when you retire and take distributions from an IRA, it is considered ordinary income, taxable at your marginal tax rate. However, if the property were outside the IRA, you could sell the property and pay the long term capital gains rate of 15% (this could go up but it will still be far less than the highest ordinary income tax rate). Under this scenario, putting real estate inside an IRA causes you to actually end up paying more in taxes because of the property being inside an IRA.
The next issue is the Required Minimum Distributions (RMD) when you turn 70 and 1/2. If you do not take the RMD the penalty is quite severe (50% of the RMD). So, if you plan to leave the property to your children or grandchildren this could create a huge problem if you don’t have the cash in the IRA to take the RMD. You could end up having to sell the property in order to take the RMD.
Ok, so we’ve ruled out the Traditional IRA and IRA Rollover. But, what about a Roth? With a Roth IRA there is no tax on distributions and no RMD. Under the right circumstances purchasing real estate inside a Roth IRA might not be a bad idea. But, Roth IRA’s have only been around for about 15 years and for the first 5 years or so you could only put $2,000 per year in. Now you can put $5,000. So, the most you could have put in at this point is about $60,000 and the market isn’t much higher now than it was 15 years ago. So, even if you are a stock picking whiz you probably don’t have more than $100,000 in a Roth IRA which really limits the number of properties available to purchase with cash. And, here are a couple of other things to consider:
1. Custodian Fees: Since the property is owned inside the IRA, you cannot write checks yourself (unless you are at least 59 and 1/2). And, if you’ve ever owned a rental property you know that you are constantly having to cut checks to vendors. Thus, you have to have your IRA held with a custodian that allows real estate investments and will cut the checks for you. Only about 2% of Broker/Dealers will actually allow this. And, of course there are fees for each payment issued from the IRA.
2. One of the benefits of owning real estate is that you can deduct the depreciation. Thus, a property could have positive cash flow and negative income at the same time. Owning real estate inside of an IRA makes this benefit irrelevant because you don’t have to file a tax return for the IRA anyway. Logically, you might say that this shouldn’t matter one way or the other since there isn’t any tax due inside the IRA. But, you should keep in mind that real estate values have already factored in the depreciation deduction for rental properties. In other words, if Congress did away with the depreciation deduction for real estate, property values for rentals would decrease, at least a little. Thus, when you purchase the property you are sort of paying for the deduction up front.
In summary, you should never invest in real estate inside a traditional IRA or IRA Rollover. In certain circumstances you should do it in a Roth. If you are at least 59 and 1/2 it would be a great way to create tax free income from a Roth, plus with check writing privileges you don’t have to worry about paying a custodian for every transaction.
