If you’re looking to diversify your portfolio and want a more stable asset class with monthly earnings it may surprise you to know that real estate could be one of your best options. There are few people who consider real estate purchases with their IRA (Individual Retirement Account) because it is not offered by many financial institutions. The usual IRA with a financial institution offers a combination of stocks, bonds and mutual funds because the institution earns an income when these asset types are purchased and held for investment. But if you have a self-directed IRA, real estate can be a part of your retirement account, along with many other types of assets.
The following retirement accounts are typically offered to individuals.
- Traditional IRA
- Roth IRA
- Simplified Employee Pension (SEP)
- Savings Incentive Match Plan for Employees or Small Employers (SIMPLE)
- 401(k) Plan
- HSA- Health Savings Accounts
These are all great options but may not allow you to invest in real property. If you would like to purchase property directly with your retirement funds, you can rollover your account into a self-directed IRA which allows you to invest in real estate. As with any IRA, a self-directed IRA adheres to the same time frames in which you can benefit from your investment. When you reach 59.5 you are able to draw from your IRA without the 10% penalty for early distribution. When you reach 72 there are required minimum distributions. With a self-directed IRA your contributions and earnings are tax-deferred, and you pay taxes when you take a distribution.
A self-directed IRA allows for alternative investments such as real estate, private mortgages, private company stock, precious metals, and intellectual property. With a self-directed IRA, a custodian/trustee is required to hold the IRA assets on behalf of the IRA owner. The custodian/trustee processes all transactions, maintains records, files IRS reports, provides statements to an owner and helps them to understand the rules and regulations of a self-directed IRA. Not all custodians handle all types of investments, so you need to be sure that the company you chose allows for direct investment in real property.
Self-directed IRA rules that affect your real estate investment:
- No self-dealing. This means that there can be no personal benefit derived from your IRA that does not come to you as a distribution. If you own an investment property in your IRA you can not stay there physically. The following disqualified persons can not stay in the property but the non-disqualified persons can.
Disqualified persons– The IRA owner and ascendant and descendant lines which include parents or your children.
Non-disqualified persons– Uncles, aunts, siblings, cousins or non-related persons.
- Do not commingle your personal funds with your IRA funds. It is important to remember that your IRA earns all the income and has to pay all the expenses. This includes any maintenance, appliance, management, or housing fees. When a property is purchased, your earnest money needs to come from the IRA as well. If for some reason the IRA is not yet open and funded, you can have a non-disqualified person place the earnest money for you and then they can be reimbursed.
- Some tax benefits of ownership do not apply if the property is in your IRA. In estate planning conversations, the concept of a step-up in basis may arise when discussing capital gains tax. When there is a step-up in basis upon the death of a property owner, this results in a reduction of capital gains tax because the tax basis steps-up to the appraised value at the time of the property owner’s passing. In many cases, if a property is sold shortly after a step-up in basis occurs, there may be no capital gains tax owed. This is good news to beneficiaries of the property owner’s estate. However, property in an IRA does not experience a step-up in basis, because the IRA is the owner of the property. This situation can be avoided if there is a distribution of the property to the owner of the IRA before their passing.
How your IRA can participate in real estate:
- Your IRA holds title to real estate.
- Tenants-in-common with a partner entity.
- This can be done with a spouse
- The percentage of ownership also determines the percentage in paying expenses, percentage in income and percentage in paying taxes.
- Loan money to a borrower who uses real estate as collateral.
- Invest in an entity that is investing in real estate.
Debt is allowed in IRAs but the rules are not widely known. This may occur if a property is purchased using both financing and the funds which exist in an IRA.
- It must be a non-recourse mortgage loan, which means that in the case of a default, the property is the only asset at risk.
- There will be unrelated business income tax (UBIT) as a result of bringing in borrowed money under the umbrella of the IRA, which has a tax exempt status.
What are some real estate investment choices for an IRA?
- Single family homes
- Multi-family properties
- Commercial property
- Vacant land
- Out of state property investments
- Leased-fee interest
- Leveraged property
- Foreclosure auctions
Many self-directed IRA companies are fee-based. The following fees are expected when opening an account.
- Application fee
- Transaction fee
- Annual administration fee
- Other bank fees
Real estate can be a good option for your IRA if you like the stability of property appreciation and steady rental income. It just requires understanding the rules of ownership and an experienced custodian/trustee to assist you in setting up a self-directed IRA. If you are interested in learning more about purchasing real estate for your IRA, please contact us. Mahalo to Dan Falardeau with New Direction Trust Company for this knowledge and guidance on the subject of self-directed IRAs.