Most investors hold traditional assets like stocks, bonds, mutual funds and exchange-traded funds in their Individual Retirement Accounts (or “IRAs”).
But some investors view direct-owned real estate – properties in which an owner, or a company controlled by that owner, hold direct title – as an attractive way to save for retirement.
IRAs are permitted to invested in non-traditional assets like direct-owned real estate, but there are some potential pitfalls to be aware of.
IRAs are subject to prohibited transaction rules. These rules are designed to prevent the fiduciary of the IRA from engaging in transactions with the IRA that could violate the fiduciary’s obligations. Prohibited transaction rules are some of the most onerous and complicated regulations that govern IRAs. This is because as the IRA owner you are always a fiduciary for your own account, which means that the prohibited transaction rules limit what you can do with your own IRA account.
The Internal Revenue Code details the various types of prohibited transactions that you may not engage in with your IRA. The list includes buying from or selling to your IRTA; lending or extending credit to your IRA; furnishing goods and services to your IRA, and using your IRA’s income or assets for your own benefit. In effect, as the IRA owner you should not benefit from your IRA, other than via distributions received from the account. And your IRA should not benefit from you, other than via contributions made by you to your account.
These prohibited transaction rules also apply to other “disqualified persons”, who include:
- Your spouse
- Your ancestors and lineal descendants
- Another fiduciary of your IRA
- Corporations in which 50% or more of the voting power or profits are controlled by persons listed above
- Partnerships in which 50% or more of capital interests or profit interests are owned by the persons listed above
- Trusts or estates in which 50% or more of the beneficiary interest is owned by the persons listed above
Generally, when a prohibited transaction occurs in your IRA, the penalty for you as the IRA owner/beneficiary is that the entire IRA is deemed distributed as of January 1 of the year in which the prohibited transaction first occurred. As a result, your entire IRA would be subject to income tax, and potentially the 10% early distribution penalty as well.
Importantly, a 15% initial penalty and an additional 100% penalty – if not corrected in a timely manner – apply to prohibited transactions engaged in by persons other than an IRA owner or their beneficiaries, as well as when prohibited transactions occur with other types of retirement accounts, such as qualified plans.
Buying and Selling
The Internal Revenue Code also prevents you (and any other disqualified persons) from engaging in the “sale or exchange, or leasing, of any property” with an asset in your IRA. This prohibition doesn’t distinguish between sales or leases made at a discount, and those at fair market value. In other words, even if your transaction with your IRA is at a market price, it is still prohibited.
Here’s an example. You use your IRA to buy a vacation home in Lake Tahoe, California, which you rent out during the ski season and the summer for $5,000 per week. When you retire, you decide you’d like to spend part of your summers in Tahoe. Unfortunately, you cannot rent the property from your IRA, even if you pay the same rent you charge third parties. Further, you cannot purchase the home from your IRA, even if you wish to do so at the market price. The only way you can use your Tahoe home without violating the prohibited transaction rules is to distribute it from your IRA. This, though, would result in your having to pay ordinary income tax on the fair market value of the home when it’s distributed, as you would with any other taxable distribution.
Another problem area for IRA owners who wish to invest in real estate relates to credit. The Internal Revenue Code states that a prohibited transaction occurs whenever there is a direct or indirect “lending of money or other extension of credit between a plan and a disqualified person”.
A direct extension of credit is fairly straight-forward to identify. This would include your IRA borrowing money from you or another disqualified person. An indirect extension of credit can be more difficult to define, though. One common violation is when you as the owner of your IRA personally guarantee a loan made to your IRA.
Investors in directed-owned real estate are often attracted to the idea of purchasing properties in need of repair, making some or all of the improvements themselves, and then “flipping” the renovated properties for a profit. Unfortunately, strategies that may work with investment made with non-qualified funds will not work with IRA dollars.
The Internal Revenue Code prohibits the furnishing of goods, services or facilities between an IRA and a disqualified person. Even painting a bedroom or repairing a leaky faucet would be a “service” provided to the IRA, and like the other prohibited transactions discussed above, there is no de minimis exception.
As a result, if you perform any work on a property owned by your IRA, it will result in a prohibited transaction and the disqualification of the IRA itself.
If you purchase a traditional investment with your IRA money, like a Vanguard mutual fund, the purchase itself is all that you’ll need to spend.
That’s not the case if you own real estate within your IRA. If the property owned by your IRA needs cash – say, for a new roof or a repaved driveway – the IRA must have, or be able to secure, the necessary cash. Because you must remain at “arm’s length” from your ITA, that cash cannot come from you or another disqualified person. Using your personal assets to pay for maintenance, repairs or other liabilities of property is prohibited.
As noted above, you cannot personally guarantee any debt associated with your IRA. So, if you want to have your IRA take out a loan to help purchase a piece of real estate, that debt must be a non-recourse loan to the IRA. A non-recourse loan is one in which an asset (in this case, the piece of real estate) is pledged as collateral, but in the event of a default there is no liability for the borrower for unpaid amounts beyond the lender’s right to foreclose on the asset itself. In the event your IRA defaults on the loan, the lender can foreclose on the property, and sell it to repay any unpaid amounts. However, if the proceeds from the sale of the property are insufficient to pay the outstanding balance of the loan, the lender cannot recover the unpaid amount from you.
Obviously, this makes a non-recourse loan to an IRA risker than a loan that you have guaranteed. As a result, many financial institutions will not make loans to IRAs for the purchase of real estate. Those lenders that will, have mechanisms for limiting their risk. These include capping the loan-to-value ratio at a level lower than they would with a full recourse, or guaranteed, loan. So, your IRA will typically need to have more cash available to purchase real estate than you would if you wanted to buy a property with a loan outside your IRA.
The financial obligations for a property don’t end once it’s been acquired. Property taxes and insurance must be paid, and regular maintenance is required. All of these expenses must be paid with your IRA’s money, regardless of how much cash the property generates.
Required Minimum Distributions and Illiquidity
Once you reach age 70 1/2, you’re required to take minimum distributions (“RMD’s”) from your IRA. If you inherit an IRA, you’re required to take RMDs from the account beginning in the year after inheritance.
As an IRA owner, while your initial RMD is less than 4% of the prior year-end account value, the percentage that must be distributed increases year by year. If the property in your IRA is not generating enough cash to continue meeting its obligations – like debt service, taxes and insurance, and maintenance – how can you satisfy your RMD? There is no exception to the RMD rules for illiquidity, and so you would be subject to the 50% penalty for any distribution shortfall.
A potential solution would be for you to take your RMD from another of your IRA accounts, if you have them.
If you don’t have another IRA, you could try a “cash out” refinance of the IRA-owned property, which would make funds available for the RMD.
Alternatively, you could try to distribute a portion of the real estate asset in your IRA “in-kind”, to satisfy the RMD obligation. Unlike IRA contributions – which must be made in cash – distributions from an IRA can be made in cash or in-kind. The difficulty lies in trying to distribute a percentage of a property. Once potential resolution to this problem involves creating a limited liability company owned by your IRA, and then transferring the property into the LLC. Then, to satisfy the RMD obligation, you could conceivably distribute a portion of the LLC interests instead. However, this can introduce a level of complexity going forward, potentially causing you to violated the prohibited transaction rules.
When your IRA is comprised only of publicly-traded investments like stocks, bonds and mutual funds, determining the market value of your account is simple.
But valuing non-traditional assets like direct-owned real estate can be more complicated and cumbersome. As an IRA owner, you’re obligated to report the fair market value of your account each year (on IRS form 5498), not just when you turn 70 1/2.
Some self-directed IRA custodians will allow you to self-report the valuation prior to your turning 70 1/2. But once you reach that age, undervaluing an asset will deprive the IRS of tax revenue, and create a risk that the IRS will audit your return, potentially adjust your valuation, and apply a 50% penalty for an insufficient distribution.
For many real estate investors, the ability to depreciate the property is one of the main attractions of this type of investment. As you know, the concept behind depreciation is that, over time, assets often lose value and eventually need to be replaced, and therefore the owner should be able to deduct that lost value in some way. That deduction for lost value reduces taxable income.
Real estate, though, can in many instances actually appreciate over time. Nevertheless, real estate purchased with taxable dollars can be depreciated, giving you a tax benefit (in the form of the permitted depreciation) while your asset actually appreciates in value.
But real estate owned in your IRA cannot be depreciated. The IRA has no taxable income, so there is nothing against which the depreciation can be applied. Distributions from the IRA do result in taxable income, but that is your income as the IRA owner, not the income of the IRA itself, and so the depreciation deduction is still not available.
It should be clear that if you’re considering direct-owned real estate for your IRA, that you need to be aware of the prohibited transaction rules. You’ll need to find a custodian that is willing and able to handle such investments. And because of the various complications outlined above, you can expect that the fees charged will be much higher than those charged by a traditional custodian.
Finally, you should be aware that while a custodian may make you aware of your obligation to comply with the prohibited transaction rules, they will almost certainly not take responsibility for ensuring that you do so.
Information courtesy of Jeffrey Levine and Financial-Planning.com
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