By Jeremy T. Rodriguez, JD
So, you want to invest your IRA money in real estate? Every so often we get this question from advisors wondering what they should look out for. Under the tax code, real estate is a permissible investment for IRAs. However, that doesn’t mean it doesn’t carry its own concerns which should cause you to think twice before jumping in. Below are some things you should take into account before using IRA money to purchase real estate.
- IRA Custodial Document – Even though the investment is perfectly legal, you need to check the custodial document before making the investment. That’s because IRA custodians can prohibit their accounts from holding real estate. In fact, many do because of the concerns mentioned herein. Thus, investing IRA money in real estate will usually call for a self-directed IRA. Even in this case you still must check the custodial agreement. If your IRA document contains this restriction and you ignore it and invest in real property, you can end up with a taxable event and lose your retirement savings.
- The Same Property Rule – If you do invest in real estate, the transaction must occur within the IRA. You cannot take a distribution of money, purchase the property, and attempt to roll the property back into your IRA within 60-days. Under the Same Property Rule, the same property that is distributed from the IRA must be the property that is rolled back to the IRA in order to count as a 60-day distribution.
- Prohibited Transactions – This is probably the biggest consideration and is the one tax payers commonly overlook. The reason it’s a big deal is if a prohibited transaction occurs, the entire IRA is taxable as of the year the event took place. There is no way to fix this mistake. The prohibited transactions rules are confusing, but generally speaking they prohibit self-dealing. The best way to think about it is to imagine every transaction the IRA engages in as occurring over a long business table. You and the IRA are on one side. If you are also on the other side of that arrangement, then you’ve potentially got a problem.
For example, you need to make sure professionals, like realtors or appraisers, are paid for with IRA money, not your own. Same with any property taxes owed and improvements made on the property. In fact, stay away from working on the property altogether. So-called “sweat equity” is a classic example of a prohibited transaction. That is true even if you pay yourself a fair market value for the services.
This also includes usage of the property. For example, let’s say you invest in a hunting lodge and rent the place out to generate income. However, one week each year, you and a few friends use the place for an annual hunting trip. If the IRS catches wind, that one-week could create a prohibited transaction which would causes the entire IRA to be taxable. Ouch!
Finally, be aware that the prohibited transaction rules include attribution features, which means we look at whether certain family members are involved in the transaction. Your spouse, parents, grandparents, children (and their spouses), and any companies they own are all included when we look at the prohibited transaction rules.
- Liquidity and Valuation – Real estate isn’t readily traded like stocks and mutual funds and therefore raises valuation concerns. Not only is this a problem when the property is purchased, but many custodians will require an annual valuation, which means annual appraisal expenses. Those documents should be retained in case the IRS audits the transaction.
Liquidity concerns are another issue. As mentioned above, expenses must be paid from IRA asset, so there needs to be enough cash or liquid assets available to satisfy these concerns. This become even more important when the IRA owner must begin required minimum distributions (“RMDs”). If an RMD is due, it must be distributed. There is no exception for IRAs with assets tied up in illiquid investments. This could force the property to be sold before it fully matures.
- Unrelated business taxable income – This could apply in two circumstances. First, if the property is debt-financed, the IRA could be subject to Unrelated Business Taxable Income (UBTI). Second, if the property is used to generate income, it could trigger UTBI. If UBTI applies, it must be reported, and taxes are paid each year (often through estimated quarterly taxes).
- Environmental hazards – Since the IRA owns the property, any responsibility for cleaning up toxic hazards could fall squarely on the IRA! Under various environmental laws, such as the Comprehensive Environmental Response, Compensation, and Liability Act (CERCLA (a.k.a. Superfund)), potentially responsible parties could be responsible for hazard waste cleanups.
In the end, real estate is a permissible investment for IRAs, and as property markets rebound around the country, they could make sense in certain situations. However, they care special concerns and heavy penalties for those that ignore them. If you are thinking about investing any portion of your IRA assets in real estate, talk with a knowledgeable advisor and discuss these issues prior to taking the plunge.