Can you really do this?
To get some solid answers, TaxMama brainstormed with Mark Luscombe, a CPA and attorney, who is the principal tax analyst for CCH, a Wolters Kluwer business.
Yes, you can buy real estate in your IRA, Roth IRA, or other retirement account. But it isn’t easy, Luscombe warns. In fact, it is quite complicated — and you’ll face many issues that might invalidate your IRA-based investment. Here are some of the obstacles you must overcome:
You must establish a self-directed IRA (Roth or regular), which may mean setting up a limited liability company or other entity to hold the assets.
Luscombe explains that you must find a plan administrator willing to allow you to use your IRA funds to buy real estate. The administrator will generally follow strict due-diligence rules. Once you find the property you want, you’ll need to convince the administrator that this property is a good investment for the IRA to own.
Be careful about the administrator you select. Just as some commission-based financial planners have a vested interest in selling you their pet investment, so do certain administrators. You want one that is not promoting properties but is simply administering accounts.
Next, roll over your retirement funds to this new retirement account. Two things you need to know about this rollover:
1. The more money you have, the better off this self-directed program will be. We’re talking about at least $100,000 or more. Unless, of course, you live in an area where you can buy rental property for $30,000 or $40,000. Find a property that will both appreciate in value and generate enough cash flow to cover all costs without your needing cash infusions annually.
2. If you don’t have enough money to buy a self-supporting property, you may need to set up the new retirement account so that you can contribute more than the $5,000 or so per year that an IRA would allow. How? Folks in business have some options: SEP-IRAs or solo-401(k) accounts. Those accounts will allow you to contribute up to about $51,000 per year, depending on your profits. Remember, these days, solo-401(k)s have Roth components, too. Consider taking advantage of them.
Regarding Roth vs. regular retirement accounts, which way should you go? When moving funds from a tax-deferred retirement account to any kind of Roth account, all the taxes must be paid for the year of the conversion. Take into account how much money you’re going to lose right up front without any special programs in place allowing you to spread your tax payments over two or four years. Depending on your tax bracket and the amount of the conversion, expect to pay 33% to 35% in federal taxes, plus your state taxes. This may be a waste of money.
On the other hand, if you’re setting this self-employed retirement account up in the first place, you can establish it as a Roth-type account. It may take you a few years to build up enough funds to buy a property, but buying real estate in a Roth account means all the assets in the account will be totally tax-free when you retire.
Of course, if you know that you, your spouse, or your dependent will be facing high medical expenses upon retirement, a regular IRA is just fine. You’ll be able to offset draws from the IRA with your medical expenses. It takes some planning.
What kind of property can you buy in your retirement account.
You may only buy a property that neither you, nor your businesses, ever use. In fact, you can’t rent the property to any related parties either — family members, businesses owned by your business, and so on. Luscombe says to be very careful about this. If at any time in the life of the self-directed account, you rent to a related party, the retirement account will lose its tax-exempt status.
Speaking of not being tax exempt, here is a concept you’ll hate: UBTI, or unrelated business taxable income. How does this come into play when your retirement account invests in real estate?
The retirement account is a tax-deferred or tax-exempt account. As long as its own funds are used for the investments, you have no problem. When you borrow money (think of mortgages), the earnings on that part of the property are no longer tax-exempt.
Say you have $200,000 in your IRA. You reserve $75,000 of those funds to cover operations and contingencies. $125,000 is used as a 50% payment on the property, borrowing $125,000 as a mortgage. Suppose you collect $25,000 in rent. Half of that money, $12,500, is allocated to the mortgaged part of the property. After deducting interest and operating expenses, suppose that mortgaged half of the property shows a profit of $5,000. You will be paying taxes on those profits each year, as long as there is a mortgage.
That is one reason to be very careful about buying property with a mortgage. Another? Suppose you lose your tenant and can’t find a replacement for several months. You will have no cash flow. If your business income that year doesn’t allow you to make a high enough contribution to cover the expenses, how will you pay the bills?
Luscombe researched whether or not you can lend money to your retirement account and found that you may only do so if the loan can be secured by the equity in the property. The amount of equity must be established by an objective third party, to ensure that you are not lending enough money to the account so that your mortgage brings the total debt to an amount higher than the property’s value (the famous upside-down mortgage).
What’s the best kind of property to buy? Find a property with a reliable long-term tenant. For instance, look at small strip malls, or 2-store commercial properties with a solid tenant. Look for NNN leases, where the tenants pay (or split) all the insurance, property taxes and maintenance on the property. All you pay is the mortgage (if any), and perhaps some backup insurance.
Another consideration for self-directed retirement accounts holding real estate is that someone must manage the property or properties. If you’re not good at asking people to pay up, or don’t like to be bothered in the middle of the night with a call about bursting pipes (or calls from police about belligerent tenants dealing drugs on your property), you will need a management company. Which means, the cash flow from the property needs to be high enough to pay its fee.
Let’s talk about fees. Property management companies tend to receive approximately 10% of the gross rents. They also get a fee for signing up new tenants — typically about 5% to 6% of the entire lease term.
Then there are the fees to set up and maintain the self-directed retirement account. Set up could cost anywhere from about $2,500 to $10,000, depending on the complexity of the account and the review of the properties. Annual fees may run as high as $2,000.
Incidentally, you definitely want checkbook control of the account. You don’t want to have to contact the administrator every time you need to cut a check. That would eat up time and add to the fees.
Also note that self-directed accounts can hold IPO-type stock, patents, copyrights, and so forth — as long as they are not your own creations. If you have an author friend in whom you have perfect faith, say, you can buy up all or part of his book’s copyright in your self-directed account. If the book becomes a best-seller (even if only an Internet best-seller), that $5,000 investment to fund printing costs could be worth $100,000 before the year is out.
Lots of people who jump on the self-directed bandwagon without really understanding how it works lose their investments altogether. But this is a very attractive and lucrative type of investment for the right person. Handled properly, it can ensure a relatively tax-free retirement.
Eva Rosenberg is the publisher of TaxMama.com. She is the author of several books and e-books, including Small Business Taxes Made Easy, and teaches tax courses at IRSExams.com and CPELink.