Buying Real Estate in Your IRA
Have you watched the prices of real estate climb each year in your community and thought about how it might be a great idea to have a rental or commercial property in your IRA? Although real estate can be a good addition for your portfolio, owning it within an IRA can be packed with problems.
One of the big attractions with real estate is leverage. You put down 10 percent or 20 percent and control a significant piece of property. From a planning perspective, debt financing is permitted in a self-directed IRA as long as the loan is set up as a non-recourse arrangement. This means that the lender must be willing to accept a security interest in the property as its sole means of legal recourse. This also means that the account holder cannot personally guarantee the debt. With this in mind, many lenders will shy away from this type of business, or will require a significant equity cushion in the property.
Assuming your IRA can find a lender, you still have a host of other federal income tax issues to consider. First, there is a special income tax on debt-financed income in retirement plans called the unrelated business income tax ("UBIT"). The UBIT rules are found under Sections 511-514 of the federal tax code. If the real estate is mortgaged, then you must also file a Form 990-T with the IRS. This form allocates the income earned between debt and non-debt financing, and helps you determine the income taxes due. So, if you want the IRA custodian to buy a $150,000 duplex for your retirement account, your IRA puts in $50,000 and borrows the remaining $100,000. On a simplified calculation, you can exclude only 33 percent of the income. The remaining income is subject to ordinary income taxes at the higher trust tax rates. Unfortunately, the trust rates hit the 35 percent income tax mark much quicker than the individual tax brackets. Once a trust has about $9,500 in taxable income, the higher 35 percent rate will come into play.
When you hold real estate outside an IRA for more than one year, profits are typically taxed as long-term capital gains (15 percent maximum). Not so with an IRA, where you must pay ordinary income rates (in the 10-35 percent range for federal income taxes) on all profits when they are withdrawn from the account. And don't forget the step-up-in-basis provision for non-IRA assets. This means that your heirs will receive your property at the value on your date of death. Unfortunately, IRAs don't work that way. Beneficiaries must use your cost basis, which is generally zero when determining their income tax liability on a sale.
What if you need to put money into the IRA property for maintenance and repairs? Once you make your annual contribution, you can't add more cash to an IRA. If this happens, you might be forced to liquidate other IRA assets to raise the needed funds.
Required minimum distributions (RMD) present yet another challenge. Once you reach age 70 �, take minimum distributions from your IRA based on your life expectancy. With this in mind, you could be left with a hard choice: sell the property, or use other IRA assets to meet your RMD. Sooner or later, all that will be left in the plan will be real estate, which may have to be sold if the rental income can't keep pace with the RMD payments.
Considering what you may face when owning properties in your IRA, you might want to look at other options. As a practical matter, there are mutual funds that own and manage real estate. They work like other funds in that they offer professional management and diversification, and can be owned within an IRA. Some specialize in commercial properties, residential rentals, or self-storage warehouses that are spread throughout the country, so you are less susceptible to regional price fluctuations or a geographically centered natural catastrophe (earthquake, hurricane, etc).
If you have been considering real estate as a way to diversify your IRA's investments, it is strongly suggested you seek out experts in the fields and consult your financial and tax advisors. There is an interesting article at the following website. www.bankrate.com/brm/news/sav/20010213a.asp
Note: Mutual funds are investments involving risk and are offered by prospectus only. Investment return and principal value will fluctuate so that upon redemption an investor's shares may be worth more or less than original value. An investor should carefully consider the investment objectives, risks, charges and expenses before investing. The fund prospectus contains this and other information about the investment company. For a copy of the prospectus, please contact your financial advisor. You should read the prospectus carefully prior to investing.
As federal and state tax rules are subject to frequent changes, you should consult with a qualified tax advisor prior to making any investment purchase decisions.
-- RAJESH JYOTISHI
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