Real estate in your IRA

Self-directed retirement vehicle gives you the flexibility to invest in property.

by Kelli L. Click   As the stock market tumbled and the balance in your retirement account marched steadily in the wrong direction, you may have wished you could use your IRA to invest in a property or two.

Thought this couldn’t be done? It can. You can use your IRA to purchase raw land, commercial buildings, condos, residential properties, empty lots, trust deeds, or real estate contracts. In general, federal law (Internal Revenue Code section 408) only prohibits an IRA from investing in life insurance policies and collectibles such as artwork, gemstones, rugs, and the like. Other investments are, for the most part, fair game.

It takes a self-directed IRA

The trick is that you can’t buy real estate with your basic IRA. You need to open a self-directed IRA–one with an independent IRA custodian that allows real estate investments. There are a handful of IRA custodians across the U.S. that will let you invest in real estate through a self-directed IRA.

A self-directed IRA is simply an IRA for which the IRA owner calls the shots. Unlike most banks or brokerage firms, an independent IRA custodian doesn’t limit your investment options to just bank CDs, stocks, mutual funds, annuities, and other common IRA investments.

And while banks and brokerage firms typically don’t allow you to invest your IRA in real estate, a self-directed IRA usually will allow you to hold not only real estate but investments such as stocks and mutual funds in the same IRA account.

Shopping for an IRA custodian

You should thoroughly check out and compare at least several IRA custodians. As when dealing with banks or financial institutions, you not only want to know whether uninvested funds are insured, you also want to inquire about the custodian’s experience and abilities. Just as important, you should compare costs and know the rules set forth by each custodian.

Fees can vary widely from one custodian to the next; so can the flexibility each custodian provides for account holders. Some custodians may permit debt-financed (leveraged) or foreign real estate properties; others will not. Likewise, some custodians may provide some property services such as filing of the deed or collection of rental income. Other custodians may require you to contract with a third party to provide these types of services. Do your homework and understand what you’re getting into.

Determine your IRA needs

If you don’t already have an IRA, one thing to consider before setting one up is deciding which type of IRA will work best for you. For an individual, a traditional or Roth IRA may be the answer. But if you are self-employed, a SEP-IRA may let you sock away as much as $40,000 each year!

With a traditional IRA, annual contributions may be tax-deductible, but taxes are paid once you start withdrawing from it. Better yet, if you qualify for a Roth IRA, you can avoid paying taxes and capital gains altogether, though annual contributions are not tax deductible. A Roth IRA might be extremely attractive if you anticipate that your real estate investments will make a lot of money.

Beginning in 2002, individuals are able to contribute more money than ever to their IRA account. The chart shows the phase-in of the new traditional and Roth IRA contribution limits, including catch-up contributions that may be made by people 50 and older.

You should consult with your tax and financial-planning professional to determine which IRA best fits your needs. But there is no limit on the number of IRAs a person can have at one time–as long as you meet the given eligibility requirements and don’t exceed the annual contribution limit.

401(k)–still another resource for real estate

Another little-known secret is that some of the independent IRA custodians that permit real estate within self-directed IRAs also allow real estate within self-directed 401(k)s–if the 401(k) is set up for a business owner with no employees. Legislative changes that became effective this year now enable owner-only sole proprietors, partnerships, and corporations to establish a 401(k) and contribute up to $40,000 each year! Couple this with the ability to purchase real estate, and a person with an owner-only business can have a powerful resource for directing her retirement destiny.

Sources for funding your IRA or 401(k)

Once you choose your custodian and determine the type of account you need, you will need to establish your self-directed IRA or 401(k). There are several ways to do this. First, you may open your IRA or 401(k) by making your annual IRA contribution as mentioned above. However, it is unlikely that you will be able to buy real estate with a $3,000 or $3,500 initial contribution.

Another method of funding an IRA almost certainly will serve you better. If you already have an IRA, you may transfer or roll over part or all of your assets from your existing IRA to the new IRA. Lastly, if you have changed jobs or quit working, you may roll over assets from your former employer’s qualified retirement plan.

Purchasing the property

IRA custodians that hold real estate will usually allow any form of real estate: raw land, residential, commercial, or rental property. Though some custodians may require that the property have no debt, your IRA may be permitted to purchase an interest in the property in conjunction with other purchasers.

Make sure that the purchase is made by your IRA custodian–not you personally. In addition, if you put up earnest money with your personal funds, you will need to make sure you include that amount in the total due so that the title company can reimburse you upon closing.

In general, your IRA custodian will require that it hold the original recorded title to the property in safekeeping. The title should reflect the name of your IRA custodian for your benefit (such as Cash Cow Trust Company, Custodian FBO Tex Smith IRA).

Keep in mind that your IRA should have some liquid funds available to pay for expenses such as taxes, insurance, and improvement costs, since these must be paid out of your IRA. If your IRA doesn’t have sufficient funds for these costs, you will have to make annual contributions within the federal guidelines or else withdraw the property from your IRA and pay taxes and possible penalties.

One further caveat that, being in the real estate industry, you probably already know: Real estate is generally not considered a liquid investment. If you are approaching retirement or anticipate that you will need to draw upon your IRA funds soon, real estate may not be the right investment for you.

Don’t let it get personal or you will run into trouble

You may be thinking of the grand possibilities–having your self-directed IRA purchase your residence, maybe even your office building. Not so fast. The IRS will not let you use the real estate owned by your IRA as your residence or vacation home. Nor can your business lease it as office space. The underlying premise for any real estate investment purchased with IRA funds is that you cannot have any personal use or benefit of the property. To do so may cost you plenty in taxes and penalties.

There are a few other limitations as well. You cannot place a real estate property that you already own into your IRA. This means that you, your spouse, or your family members (unless it’s a sibling) could not have owned the property before it’s purchased by your IRA.

After you retire, however, you can take a property out of your IRA as a distribution (at the current market value and pay any taxes if your account is not a Roth IRA) and then move in.

Don’t forget your clients–they can benefit, too

Investing in real estate through a self-directed IRA might be of interest to some of your clients as well. While they must use an IRA custodian to set up their retirement account, they certainly can rely on you to provide real estate brokerage services.

Whether for your clients or yourself, a self-directed IRA can certainly open up more options when building wealth for retirement.

Kelli L. Click (800/955-3434, ext. 250) is vice president of services and marketing with Sterling Trust Company in Waco, Texas, a self-directed IRA and 401(k) custodian for more than 18 years.

Photo © PictureQuest.

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