The Rules for Investment Properties Within an IRA
The first thing to understand is that you are not the property owner. Your IRA is, and that will be stated on the deed. The second is that none of the income the property generates can directly benefit you; it can only benefit the IRA. Most of the other rules fall under those two presuppositions.
The IRA you use, whether conventional or Roth, must be held by a self-directed custodian. IRAs have been overseen by custodians for tax accountability since 1974, but traditional custodial banks and brokerages offer only limited investment options such as stocks and mutual funds. A self-directed IRA allows you to diversify your retirement portfolio with alternatives like investment property. That is one of the biggest perks.
There is another important difference between traditional custodians and self-directed ones: Custodians of self-directed IRAs, beyond directing you to IRS resources, do not give legal tips or tax advice. They manage transactions and report to the IRS as required to keep you in compliance with the rules, but their fees cover only those services. They do not provide an education or suggest best practices. You must make property investment decisions without their help.
In other words, when it comes to investing through the IRA, you are on your own for the most part. That is one risk that many passive investors are not willing to take.
In the eyes of the IRS, you and your self-directed IRA are completely separate entities. This arrangement is strictly for the purposes of passive investing. You cannot enjoy property-generated income until it is time to start making withdrawals from the IRA. Since one prohibited transaction can result in your IRA becoming taxable income, it is best to think of the account as a complete stranger you look forward to meeting someday.
For instance, if you purchase a home with funds from the IRA, you cannot live in it, work from it, start a business in it, or even stay in it on vacation. There is a long list of IRS-disqualified people who cannot benefit in any way from the property. The shortlist includes the following:
• You.
• Your spouse.
• Your children and their spouses, children, and grandchildren.
• Your parents, grandparents, and great-grandparents.
• Any beneficiary of the IRA.
• Plan service providers or any custodian, adviser, or an administrator.
Also, you cannot use the IRA to buy property from anyone, including yourself, who is on the disqualified list.
Purchasing Property
No one argues that buying a property through an IRA requires substantial wealth. Mortgages are hard to come by and are quite complex, so paying cash is the preferred alternative.
That calls for a very high account balance. Not only will you have to pay for the property itself, but most advisers recommend that you have enough saved for several months’ property expenses at the very least.
If you do find a lender who specializes in loans to IRAs, you are not personally guaranteeing the mortgage, so the loan will have to be nonrecourse. If you stop making payments, the only asset the lender can go after is the property itself. That means the lender will require a sizable down payment of around 40% to 50% and charge much higher interest rates than those in a conventional mortgage.
There is something else you have to watch for if your IRA makes a debt-financed purchase. Any revenue the property generates might be considered unrelated business taxable income, or UBTI.
Whether you pay cash or obtain financing, there is no tax consequence to buying, selling, flipping, and amassing properties within the IRA. You can freely roll funds among various projects.
Owning Property
Remember that the IRA owns the property. That is where things get a little strange.
You cannot manage the property, landscape around the pool, repaint the guest room or even change a light bulb. You must pay someone else to care for your property, and that someone cannot be anybody on the disqualified list.
If the IRA buys a ski lodge, say, you may not furnish it with antiques you have collected from around the world. If the IRA buys a chain of boutiques, neither you nor anyone on the disqualified list may work in the shops or purchase items from them. This is passive income at its most passive.
You are breaking the rules if you pay for repairs or ongoing maintenance out of your own pocket. Instead, you will fund the IRA to pay for expenses. That can get tricky because contributions are limited. If you have a string of expensive repairs, you could incur high penalties for overcontributing.
All rental income goes into the IRA. It is tax deferred, of course, until you withdraw from the IRA in retirement.
This is an excellent way to go about wealth building, but be aware that you are excluded from certain perks that traditional property owners enjoy. You cannot deduct mortgage interest, depreciation, property tax and other expenses associated with owning property.
Selling Property
This is a simple matter of negotiating the price and terms and asking your custodian to sell the property on your IRA’s behalf. Proceeds from the sale will go directly back into your IRA. No capital gains tax is owed, and the reinvestment is tax-free for now.
The Bottom Line
The IRA plan is not ideal for every passive investor. For example, if you had planned to purchase rental properties that you and family members could enjoy now and then, this is not the right solution for you. If purchasing property through an IRA would require a loan, there are better options with more favorable terms. If you lack experience in real estate investing in general, get some practice buying rental properties the old-fashioned way before you take this route.
Otherwise, you are a great candidate for investing in property with an IRA, and there are some great incentives.
Real estate almost always pays excellent returns over the long term. It is largely recession-proof. Property values are never as volatile as stock prices, and rental property occupancy rates tend to hold steady even in weak economies.
In short, there is much to like about this type of passive investing. It is a great vehicle for building wealth and diversifying your retirement savings.