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Online Exclusive: Buy Real Estate in Your IRA
Retirement Planning
Buy Real Estate in Your IRA
A little-known IRS provision lets you extend your real estate purchasing with tax-deferred dollars.
BY KELLI L. CLICK
Are stock market woes preventing you from building wealth in your retirement account? If so, you might be interested in a small, but growing, trend among individual retirement account owners—investing their retirement funds in real estate.
How It Works
If the option of using tax-deferred funds to purchase property sounds appealing, you’ll need to locate an independent IRA custodian that allows real estate investments and work with that company to set up an IRA account. Most banks and brokerage companies—the most common IRA account options—limit your choices to certificates of deposit, stocks, mutual funds, annuities, and similar financial instruments. But Section 408 of the Internal Revenue Code permits individuals to purchase land, commercial property, condominiums, residential property, trust deeds, or real estate contracts with funds held in many common forms of IRAs, including a traditional IRA, a Roth IRA , and a Simplified Employee Pension plan, or SEP-IRA.
To find a custodian that specializes in real estate, search under terms such as “real estate IRA” or “self-directed IRA.” This latter term was coined by the financial industry in the 1980s to distinguish the self-directed IRA from other IRAs that focus on stocks and bonds. The IRA account holder can’t serve as the custodian of his or her own account. However, it’s important to select a custodian knowledgeable about the types of investment you’re interested in, because the custodian holds title to the real estate. Do your homework, and understand what you’re getting into.
Fees can vary widely among custodians, as can the flexibility of the services provided for account holders. If the custodian holds real estate on your behalf, but does not service it (collect the rent, etc.), you may have to contract with other providers. However, be sure that all rents are paid into the IRA and that all taxes are paid by the IRA.
Purchasing the Property
Most IRA custodians that hold real estate will usually allow you to purchase raw or vacant land, residential properties, or commercial buildings for your portfolio. In addition, some custodians may permit foreign property or leveraged property.
Since buying a property may require more funds than you currently have available in your IRA, you also can have your IRA purchase an interest in the property in conjunction with other individuals, such as a spouse, business associate, or friend. Also keep in mind that if the property is leveraged, the debt must be a non-recourse promissory note.
Unfortunately, Internal Revenue Service regulations will not let you use the real estate owned by your IRA as your residence or vacation home. Nor can your business lease space in your IRA-held property. The underlying premise for any real estate investment purchased with IRA funds is that you can’t 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 IRS limitations as well. You cannot place a real estate property that you already own into your IRA. Your spouse, your parents, or your children also couldn’t have owned the property before it was purchased by your IRA. Property owned by siblings may be allowed, since the Internal Revenue Code (section 4975) specifies that only “lineal descendents” be disqualified.
Once you’ve chosen a property, your IRA custodian—not you personally—must actually purchase it. The title will reflect the name of your IRA custodian for your benefit (such as Silver Trust Co., Custodian FBO John Doe IRA). In addition, if you put up earnest money with your personal funds, you’ll need to make sure you include that amount in the total due so that the title company can reimburse you upon closing.
Operating an IRA-held Property
Because all property expenses, including taxes, insurance, and repairs, must be paid from funds in your IRA, you’ll need liquid funds available in your account. Of course, all income generated from the property will be deposited in your IRA account so you can use that money to cover your costs. You also can make annual contributions within federal guidelines.
Currently, you can contribute $5,000 annually to a traditional or Roth IRA ($6,000 if you’re age 50 or older) and as much as 15 percent of your annual compensation, up to $40,000, if you’re a self-employed individual with a SEP-IRA. If your account doesn’t have funds to cover property expenses, you will have to withdraw the property from your IRA and pay taxes on the value of the property, as well as possible penalties for early withdrawal.
It’s also possible to sell properties while they are held by your IRA, so long as the purchaser is not a family member. Once a deal closes, your IRA account now holds the cash proceeds—ready for you to make your next investment. An alternative is to sell an IRA-held property with seller financing so that all payments made by the buyers are paid to the IRA.
Distributing Your Property
You can withdraw real estate from your IRA and use it as a residence or second home when you reach retirement age (age 59½ or older for a penalty-free withdrawal). At that time, you can elect either to have the IRA sell the property or take an in-kind distribution of the property. Under that arrangement, your IRA custodian assigns the title to the property to you. You will then have to pay income taxes on the current value of the property if it’s been held in a traditional IRA. If the property was held in a Roth IRA, you won’t owe taxes at distribution. This makes a Roth IRA extremely attractive if you anticipate that your real estate investments will appreciate over time.
Whether your retirement strategy is to hold properties or buy and sell for gain, real estate investing through your IRA can yield extraordinary returns toward your future retirement.
IRA Options
While any form of IRA allows for real estate investment, there are other pluses and minuses to consider when choosing the account type that’s best for you:
- A traditional IRA lets you deduct annual contributions (currently set at $5,000, or $6,000 if you’re age 50 or older) from your income. However, once you begin withdrawing money, those funds will be taxed as regular income.
- A Roth IRA gives you no deduction on your current contributions (again $5,000), but does allow you to withdraw funds tax-free. If you expect to buy a real estate investment in an IRA and hold it for a long period, this is probably your best option, particularly if the property increases in value over that period.
- A SEP-IRA is designed for self-employed individuals and small companies. You can contribute up to 25 percent of your compensation, or $40,000, whichever is less. However, keep in mind that if you have employees, you must make contributions for them as well. This option is a great alternative for real estate practitioners who can make the higher contributions because they can build up funds more rapidly to purchase properties. Withdrawals from a SEP-IRA are treated like those of a traditional IRA for tax purposes.Kelli L. Click is vice president of sales and marketing at Sterling Trust Co., a self-directed IRA and 401(k) custodian, in Waco, Texas. She can be reached at 800/955-3434, ext. 250.
First Time Home Buyer – using your IRA funds?
Requirements to be considered a first-time homebuyer under IRA rules.
If you receive a qualified first-time homebuyer distribution from a regular IRA you don’t have to pay the 10% early distribution penalty even if you’re less than 59½ years old. And if you take a qualified first-time homebuyer distribution from a Roth IRA after you satisfy the five-year requirement, you don’t have to pay tax on the distribution.
To have a qualified first-time homebuyer distribution, you need to meet all of the following requirements, which are discussed below:
* The purchase must be a principal residence.
* The person for whom it is a principal residence must be the owner of the IRA or a family member (within limits).
* The person for whom it is a principal residence must be a “first-time homebuyer” (generally someone who has not owned a home in the previous two years).
* The purchase must cover “qualified acquisition costs.”
* The owner of the IRA may not treat more than $10,000 as qualified first-time homebuyer distributions (a lifetime limitation).
* The purchase must be made within the applicable time limit.
* Principal residence
* The qualifying purchase does not have to be a traditional home. For example, a houseboat may qualify for this purpose. But the purchase must be a principal residence. It can’t be a vacation home where you or your family member stay for a small part of the year.
IRA owner or family member
You can’t use this IRA distribution to buy a home for just anyone. It has to be for yourself, your spouse, your child, grandchild or ancestor, or your spouse’s child, grandchild or ancestor. If you choose to help a sibling, or a niece or nephew, the rule doesn’t apply.
First-time homebuyer
The rule only applies if the person who will use this home as a principal residence is a first-time homebuyer. This is not necessarily someone who has never owned a home, but it must be someone who has not owned a principal residence during the two-year period ending on the date of acquisition of the new home. If that person is married, the spouse must not have owned a principal residence during that period, either.
Qualified acquisition costs
This is a fairly easy requirement to meet. The amounts paid must be costs of acquiring, constructing, or reconstructing a residence, including any usual or reasonable settlement, financing, or other closing costs.
$10,000 limit
This rule is subject to a lifetime limit of $10,000. It appears that this limit applies to the IRA owner, not the purchaser of the home, if these are two different people.
Example: Your son needs $20,000 for the down payment on a home. For this purpose he will take $10,000 from his IRA and you will take $10,000 from your IRA. Assuming neither you nor your son has taken a previous qualified first-time homebuyer distribution, both distributions will qualify.
Example: Your son and daughter each need $10,000 for the down payment on a home. For this purpose you take $20,000 from your IRA. Only the first $10,000 will be a qualified first-time homebuyer distribution.
When you determine whether you are a first-time homeowner you must take into account any previous ownership of a principal residence by your spouse. But it appears that the $10,000 limit applies separately to each spouse.
Example: You need $20,000 for the down payment on a home. For this purpose you and your spouse each withdraw $10,000 from an IRA. If you meet the other requirements, both distributions can be qualified first-time homebuyer distributions.
It appears that if you are withdrawing from a Roth IRA for this purpose, only the amount of the distribution that exceeds your previous contributions counts toward the $10,000 limit.
Example: You have $14,000 in your Roth IRA, including $8,000 of contributions and $6,000 of earnings. If you meet the other requirements, you can use the entire Roth IRA for the purchase of a principal residence, using only $6,000 of your lifetime limit.
Time limit
Your distribution won’t qualify if you take the money out of the IRA too far in advance of the closing of your purchase. The payment must be used to pay qualified acquisition costs before the close of the 120th day after the day on which the payment or distribution is received from the IRA. If you take money out of your IRA and then run into a last minute snag that prevents you from using the money within this time limit, you’re permitted to contribute the money back to your IRA (or to a new IRA) within the 120-day limit and treat the distribution and contribution as a rollover. The 60-day rule that normally applies to rollovers will not apply, and this special rollover is disregarded when you apply the rule that permits only one rollover within a 12-month period.
This information above is not Tax or Legal advise. Seek competent Tax advise from a competent Tax advisor.
* This information above is not Tax or Legal advise. Seek competent Tax advise from a competent Tax advisor.
December 17th, 2009 at 6:44 pm
I had no idea – thanks. I will check with my tax guy.