This week Gail examines the many potential pitfalls of investing IRA money in rental property.
The real estate market here in southern California has started to cool off, but I have to believe this is just temporary. There’s a limited amount of land out here and the population only seems to increase.
So I’m thinking of buying a rental property. Because I can’t see myself moving from this area, I plan on this being a long-term investment — at least 10 years.
I’ve started seeing articles about the benefits of having your IRA own real estate. Is this legal? What do you think of the idea?
The quick answers to your questions are: 1) Yes, but it’s very complicated; and 2) Because of answer No. 1, I am very, very hesitant to recommend it. One small mistake and you risk losing all of the tax savings –- and more — that proponents of this strategy promise it can deliver.
Granted, it’s hard to ignore a screaming pitch like this one from the self-proclaimed “Titan of Tax-FREE Real Estate Deals”:
”How to Make an Absolute Killing in Real Estate Without Paying Even One Thin Dime in Taxes- EVER!”
Frankly, who wouldn’t find it enticing to think of avoiding taxes on all those juicy gains you imagine racking up by turning your IRA into a real estate mogul? But if it were that simple, don’t you think everyone would be doing this?
Don’t just take my word for it. Attorney Natalie Choate is a nationally-recognized guru when it comes to what you can and cannot do with your retirement accounts. Her book, “Life and Death Planning for Retirement Benefits” is considered one of the definitive sources of information on this subject.
Here’s what Choate has to say: “It is legal for your IRA to invest in real estate. My concern is that it’s being presented in an over-simplified way.” According to Choate, there are four fatal mistakes you can potentially make and, frankly, I didn’t see any of these adequately addressed on any of the websites promoting this.
The first concept to grasp is that you cannot personally own the real estate. Your IRA custodian will actually hold the title. However, your typical IRA custodian doesn’t have the systems in place to handle anything more than mutual funds, stocks, bonds, and other publicly-traded securities. Which means you’ll need to use a custodian who specializes in IRAs that own real estate, such as those promoting this idea. (You can find plenty of willing candidates by searching the internet under “real estate IRA.”)
Caution: not all custodians are created equal. And their fees reflect this.
According to Choate, the first potential pitfall you can run into is something called
“unrelated business tax income” (UBTI). The tax code specifically states that the income an IRA earns is tax-exempt unless it falls into the category of UBTI. Without going into a long explanation, one type of UBTI is income from debt-financed property.
“That’s the reason,” says Choate, “that you can’t have a margin account in your IRA.”
So, if your IRA has to take out a mortgage to buy the property, a portion of your IRA becomes taxable. This means that your IRA has to file its own tax return every year.
Then there’s the related issued of how your IRA pays income and property taxes. Don’t feel bad if you didn’t see this mentioned on any of the websites offering to help you set this up. Neither did I.
The point is, your IRA needs to have its own separate checking account.
Be careful! If you make the mistake of withdrawing money from your traditional IRA and paying the tax bill yourself it’s considered a “distribution” and you will owe income tax on this amount and possibly a 10 percent early withdrawal penalty if you are under age 59½.
Ideally, to avoid this predicament your IRA custodian should be the entity that withdraws the tax money from your IRA and sends it to the appropriate government agency. But this goes back to the issue of using a custodian that is capable of handling such transactions.
As previously mentioned, there are significant differences among custodians. Some will only hold the title on your behalf — period. As an article “Buy Real Estate for Your IRA” in Realtor Magazine Online points out, if your IRA custodian will only hold title to the property, “but does not service it (collect the rent, etc.), you may have to contract with other providers.”
That’s right: You are prohibited from being personally involved in the management of this property. This includes normal upkeep such as painting, mowing the law, fixing a leaky faucet, etc. More on this later.
Co-Mingling IRA & Personal Assets
Choate also worries that “it’s extremely hard for the average person” to keep their personal and their IRA finances separate. If you inadvertently mix up them up there are serious consequences.
Let’s say you make a mistake and pay the painter of the IRA property from your own checking account. Oops! That will be deemed a “contribution” to your IRA. If the amount exceeds what you can legally contribute to an IRA in a single year ($4,000 this year; a total of $5,000 if you’re over age 50) it will be considered an “excess contribution” and subject to a 6 percent penalty.
You can trigger an inadvertent “distribution” if the IRA pays for one of your bills. Say you go to the hardware store and pick up some grass seed, caulking, light bulbs, and faucet assembly. The caulking and faucet are for the rental property. You put the entire amount on your charge card.
You then write a check from your IRA’s checking account to reimburse yourself and mistakenly write it for the whole amount. Bingo! You’ve just taken a “distribution” from your IRA. If it’s a traditional IRA you’ll owe income tax and possibly a 10 percent penalty on this amount.
To be on the safe side, “you should have a professional real estate management company manage the property,” says Choate. “They are writing the checks, paying the bills. Your IRA would get a check every month from the management company.”
Guess what? That costs more money.
The tax code specifically lists things you absolutely cannot do with your IRA investments, a.k.a. “prohibited transactions.” Many involve actions that involve “disqualified persons.” Some ads and websites, says Choate, “give misleadingly simplistic advice on this subject.” (Could it be that they’re just interested in collecting their fees for acting as custodian?)
This is so important, I’m reproducing a portion of Internal Revenue Code Section 4975:
For purposes of this section, the term “prohibited transaction” means any direct or indirect —
(A) sale or exchange, or leasing, of any property between a plan and a disqualified person;
(B) lending of money or other extension of credit between a plan and a disqualified person;
(C) furnishing of goods, services, or facilities between a plan and a disqualified person;
(D) transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan;
(E) act by a disqualified person who is a fiduciary whereby he deals with the income or assets of a plan in his own interests or for his own account; or
(F) receipt of any consideration for his own personal account by any disqualified person who is a fiduciary from any party dealing with the plan in connection with a transaction involving the income or assets of the plan.
You yourself are a “disqualified person” because you are the “fiduciary” of your IRA (you do choose the investments, right?). Other disqualified persons include relatives who are your “ancestors” (parents, grandparents), “lineal descendants” (children, grandchildren, great-grandkids or anyone married to these individuals), or your spouse.
So don’t even think about having your IRA buy your grandfather’s condo in Boca when he enters the assisted living facility. All transactions made by your IRA must be arms-length, i.e. with a disinterested third party.
In a similar vein, neither you nor any “disqualified person” can benefit from any transaction your IRA makes.
That vacation cabin you thought would be cool for your IRA to own? You know, the one you are going to rent except for one month each year when you and your family plan to use it? Fahgetaboutit!
Furthermore, according to Choate, even if a transaction in directly benefits the IRA owner or his/her family members, this violates the prohibited transaction rules. “For instance,” she says, “Say you rent the apartment owned by your IRA to your mother-in-law.” Since in-laws are not “disqualified persons” you probably think you’re in the clear.
However, she adds, consider the possibility that “if you don’t rent the apartment to your mother-in-law she will have to move in with you.” Gotcha! Renting the IRA-owned apartment to your mother-in-law provides an indirect benefit to you, making this a prohibited transaction.
In fact, says Choate, any transaction that provides “an indirect benefit to the IRA owner, his/her parents, or children would be just as prohibited as a ‘direct’ transaction.”
She gives another example: Say you own a home next to some vacant land. You find out that the county plans to buy the property and use it for a toxic waste dump. To prevent this, you contact the owner — an unrelated third party — and have your IRA buy the land first.
Gotcha again! Because you personally benefited from the fact that the adjoining property was not turned into a dump, this is a prohibited transaction.
While Choate is concerned that most of the advice about having your IRA own real estate is incomplete and overly-simplified, I’d argue that it’s downright misleading. It’s not enough to consider who directly benefits. You also have to look at how “disqualified persons” might indirectly receive a benefit.
In case you’re wondering, if the owner of an IRA is involved in a prohibited transaction, the penalty is that the entire IRA is disqualified — as in, immediately and completely taxable! Check out Section 408 (e)(2) of the Internal Revenue Code.
There goes the promise of not having to pay tax on the real estate in your IRA.
No Sweat. Literally.
The fourth potential pitfall occurs when you contribute “sweat equity” to the real estate held by your IRA by doing such things as repairs, or making improvements. That would constitute “furnishing services” and also violates the prohibited transaction rules (see item (C) above). Choate adds that it might also “cross the fine line that separates managing an investment — which is OK — to operating a business inside your IRA — which is not.
“If you are performing services that are producing income for your IRA, the IRS is likely to say that is your income, not the IRA’s income. Therefore, you should be reporting and paying taxes on it — not sheltering it inside your IRA,” says Choate. She adds, “It is as if you’re having your paycheck given to the IRA. You’re entering dangerous territory.”
Here’s another example: Suppose you get a call from the tenant complaining the toilet is clogged. According to Choate, “If you call a plumber, that’s considered ‘management.’ If you go in yourself with a plunger, that may be construed as ‘operating a business.’ ”
So far the IRS has apparently not taken a hard look at these arrangements. But if the idea of owning real estate inside your IRA takes off, it’s probably a good bet that we’ll be seeing cases turn up in tax court.
Choate says another way the IRS could attack these schemes would be to deem that since the work you did improved the value of the property owned by your IRA, it was, in effect, an IRA contribution. And, to the extent you exceeded your annual IRA contribution limit, you would have to pay a 6 percent “excess contribution” penalty.
Can you see why having your IRA invest in real estate makes me extremely nervous?
Real Simple IRA Real Estate Investing
There is a simpler way to own real estate inside your IRA: Invest your IRA in a Real Estate Investment Trust (REIT), or limited partnership, or mutual fund that owns real estate. All of these can be purchased in the securities markets, which satisfies the rules about prohibited transactions (assuming you don’t have any direct role in running or selecting the real estate these investments) and eliminates the possibility of co-mingling funds, paying taxes, etc.
Moreover, you get the added protection of owning a diversified portfolio. Most people who buy rental property naturally pick real estate in the same area where they live because it’s more convenient to keep an eye on your investment.
Talk about putting too many of your retirement nest eggs into one basket! If the real estate market in your area tanks, both your personal residence and your investment property — i.e. your retirement — take a hit.
In conclusion, directly investing your IRA in real estate is not something to enter into lightly. Be prepared for higher costs to set this up as well as on-going charges. Be sure you investigate your custodian thoroughly. What experience do they have? How long have they been doing this? What services will they provide in exchange for their fees?
And be sure you resist the tendency to play “landlord.”
Hope this helps,
If you have a question for Gail Buckner and the Your $ Matters column, send them to: email@example.com, along with your name and phone number.