Abysmal returns from stocks, bonds and mutual funds, and fear of another crash have a lot of people turning to alternative investments like gold or real estate. Investments such as art, antiques, precious gems, stamps, coins and other collectibles are not permissible investments for an IRA under any circumstances.
What about investing the IRA in real estate? Real estate is not per se prohibited. You can invest your IRA in some types of real estate - it would have to be a self-directed IRA with a custodian who permits real estate investments. But the risk with real estate is running afoul of the prohibited transaction rules. Here are some prohibited transactions: directly or indirectly 1) selling property you own to your IRA or having your IRA buy your personal assets; 2) borrowing money from your IRA; 3) loaning money to your IRA; 4) using your IRA as security for a loan; and 5) receiving services from or providing services to your IRA. You can't do these things through a company you own or through a family member. Even if the transactions are arms-length, commercially reasonable and fair, they are prohibited.
Companies that promote real estate investments for IRAs may mention these issues but don't want to discourage you from using their services. They usually refer you to your tax professional. Some folks don't bother to check, and some tax professionals are unaware of the rules.
If you have a prohibited transaction, the whole IRA becomes taxable based on the total account value as of the start of the year in which the transaction occurs. The IRS can apply a 10% early withdrawal penalty. If a fiduciary such as a trustee or investment manager (other than you) participates in a prohibited transaction, a 15% additional tax on the amount involved can be charged to that person or company. This tax can increase to 100% if the transaction is not corrected in the year in which it occurred. This penalty tax on third party fiduciaries is intended to ensure your custodian or investment manager takes the rules seriously.
While it is possible to navigate around these rules and have some real estate investments in your IRA, it requires a lot of work, is very complex and expensive. If you are still set on doing it anyway, how would you do it?
IRA Expert Natalie Choate gives these four steps: 1) Transfer your IRA to a custodian that specializes in holding real estate, 2) Have the bank-custodian purchase the real estate investment inside your IRA. You cannot buy the real estate first then transfer it to the IRA. You cannot buy the real estate yourself and then sell it to the IRA. 3) Hire a real estate management company to manage the property. The management company collects the rents, pays the bills, takes care of maintenance, and sends a net check to your IRA custodian every month. 4) Do not have the IRA transact with you or with anyone you have a relationship with. Don't rent to family members, don't hire family members to make repairs, do not spend your vacation in an IRA owned condo.
Even if you can successfully navigate the complex rules to have your IRA invest in real estate, it is not a tax-wise move. Much of the benefit of real estate investments is in the tax shelter available through expense deductions and depreciation. For property owned in an IRA you can't deduct any expenses, property taxes, insurance, mortgage interest, or depreciation. Further, when the property is sold, all gain is taxed as ordinary income when distributed from the IRA - which were it not in the IRA would be capital gain. Why would you want to turn capital gain into ordinary income?
The IRA would have to maintain a sufficient cash balance to pay all taxes, expenses, and costs of improvements, as well as fees because you personally cannot provide any funds to the IRA for any of these purposes. All income generated by the real estate must stay in the IRA and can only be distributed in accordance with the distribution rules. For example, any distribution before you are 59-1/2 would be subject to a 10% premature distribution penalty as well as being 100% taxable as ordinary income.
There is also an annual valuation requirement for IRAs. When they hold marketable securities or cash equivalents, this is easy to meet because market values are readily available. In the case of real estate, the IRA would have to incur the cost of annual appraisals.
If you are over 70-1/2 or if you die, there are distribution requirements from the IRA. How can they be met if the IRA has no liquid assets? This is a difficult problem. A deed transferring a fractional share of the real estate could be used to make a distribution; but that is costly and ,also, it is difficult to determine the value of the fractional shares for purposes of meeting the minimum distribution requirements.
If you really want real estate investments in your IRA, it is much safer to stick to something like a real estate investment trust, which has publicly traded units that won't run afoul of the prohibited transaction rules.
