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ON THE MONEY: Using a self-directed IRA to purchase real estate

Greg Roberts

Greg Roberts

When it comes to your IRA, you are probably like most other retirement-conscious savers in that your funds are held by a bank, mutual fund or other investment firm. In my IRA account, I can purchase any of the products offered by my investment firm, including individual stocks, bonds and mutual funds, ETFs, or CDs.

You may be unaware that originally, an IRA could invest in virtually any type of investment with one exception-life insurance. This prohibition was the result of a strong lobby effort in the ’70s on the part of the big banks and stock brokerage firms who were fearful that the life insurance industry could capture the bulk of the IRA market.

Later, collectibles were added to the list of non-permitted IRA investments. These include works of art, rugs, antiques, precious metals and stamps. In 1997, certain coins, minted either by the federal government or by a state, were deemed to be suitable investments.

One minor drawback of an IRA is that you may not invest your own funds personally, but must have a trustee or custodian actually handle your money and purchase the investments for you, since you would be engaging in a big no-no if you did otherwise. Qualified plans of all types define "prohibited transactions" as those occurring between "disqualified persons" and the plan itself, and an IRA owner/participant is a disqualified person. In a word, no self-dealing.

However, ERISA did contain a provision that allowed for what are known as self-directed IRA’s, which allow the participant to instruct the custodian or trustee of the IRA what to invest it. One intriguing investment choice within these self-directed IRA’s is real estate. For example, say that I wanted to purchase rental property in Aiken, and I had at least a portion of my IRA assets in a self-directed account. I could negotiate with the seller to obtain the best price and then have my IRA custodian disperse the purchase price, and voila, my IRA now owns rental real estate.

I could not manage the property personally, but the custodian could hire a property manager, and any expenses, such as maintenance fees, repairs and the like would be paid from my self-directed account. Moreover, I could not rent the property to any relative or business acquaintance.

All rental income would be paid to the custodian on my behalf, and when the property is subsequently sold, the gain on the sale would be credited to my IRA.

Using IRA assets to purchase real estate has several shortcomings: first, no IRA property can be purchased with borrowed funds, since having debt financed property within a tax-exempt entity subjects that entity to UBIT, or unrelated business income tax. The better approach is to simply pay cash for the property.

The larger issue is maintaining enough liquidity within the IRA to be able to disperse required minimum distributions each year after the IRA owner turns 72.

A cottage industry has emerged in response to the lack of leverage generally available to IRA’s, and it works like this: you form a limited liability company, and your IRA invests in it. In so doing, you would have control over the LLC assets, and the LLC could purchase real estate on your behalf and avoid any prohibited transactions. The LLC then would pass all rental income to the IRA. By utilizing the LLC as a go-between, you avoid the UBIT.

However, there are a myriad of tax compliance issues with such vehicles, and it has been estimated that less than 1/2 of these self-directed IRA's using LLC's are handling these tax and legal issues correctly. My advice is: if you want to purchase real estate in your IRA, pay cash. Be sure to check with your accountant before moving ahead with this approach.

One of the reasons that IRA owners consider purchasing real estate as part of their retirement accounts is to obtain diversification in their IRA’s. One problem now is that the real estate market in Aiken is skewed in favor of sellers. As a result, bargains are few and far between.

Personally, I would never purchase real estate in my IRA: the set-up and ongoing administration costs, coupled with tax compliance issues are simply not worth it. I can diversify my IRA assets via other, less expensive means.

One other important point: if you have a Roth IRA, use it to satisfy your real estate investment thirst. Any investment that has the potential to grow substantially should be purchased in a Roth IRA, since there are no taxes on the back end. This takes on added significance if you intend to leave your Roth account to children and/or grandchildren.

Just ask Max Levchin, one of the founders of the social review site, Yelp. At one time he had $3.9 million of low-basis shares in his Roth IRA, and since the stock is now trading at $21 per share, his shares are now worth almost $82 million. And the best part? None of those gains will ever be taxed.

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