For many years now, people have been using non-directly owned real estate in their IRAs and other retirement plans. These intangibles are investments like REITs and real estate mutual funds. Most people didn’t know they could use the retirement plans to purchase directly owned real estate such as raw land, commercial buildings, condos, residential properties, empty lots, trust deeds, or real estate contracts.
In general, the Internal Revenue Code (IRC) section 408 does not prohibit the holding of real estate in an IRA, provided the transaction is not prohibited under IRC Section 4975.
Code section 4975 covers what transactions are prohibited between an IRA or retirement plan and a “disqualified person”. Generally, “disqualified persons” are defined to be the account holder, other fiduciaries, certain family members, and businesses under the account holder’s control. In essence, the prohibited transaction rules prohibit an IRA or qualified retirement plan from owning a piece of property which will be purchased from or use personally by the account holder, family members, or businesses under the account holder’s control. Simply put, the property must be used for investment purposes only and cannot be used personally while maintained in the IRA. In addition, properties that are individually owned outside of the IRA cannot be transferred or purchased by one’s individual IRA.
Remember, the IRS will not let you use your IRA to purchase your home or vacation home. Nor will they let your business lease property from your IRA. You cannot have personal use or benefit from the property. If you did, it could cost you plenty in taxes and penalties.
However, it may make sense to take the property out of the IRA as a distribution and live in it during retirement. Make sure not to move in until the distribution is complete. The distribution would need to be at the current market value as of the date of distribution, and taxes would be due unless your account was a Roth IRA. This may be a good reason to convert your IRA to a Roth. Further, if you are under the age of 59 ½, a 10% penalty may also apply.
Example: Convert your IRA to a Roth IRA and pay the income taxes now. Once the conversion is complete, use your new Roth IRA to purchase a residential rental property in a location in which you may want to retire. Rent the property until retirement. When you are ready to retire, take the property out of the Roth IRA as a tax-free distribution, assuming you follow the rules, and then you may live in the property.
For those of you who stopped reading and immediately called your basic IRA provider so you could get started investing in real estate right away, you probably were told that you were not allowed to do so and now think I’m crazy. So, now that you’re back, let’s find out how you go about doing this.
The first key step to investing tax-deferred or tax-exempt in real estate is to open a self-directed IRA with any one of the dozen or so independent IRA custodians that allow real estate investments. Remember, just because it may be okay with the IRS does not mean your local bank, stockbroker, or insurance company will provide this service.
A self-directed IRA is simply an IRA where you are in control of your investment options and are not limited to just stocks, bonds, mutual funds, and other traditional securities. In a self-directed IRA, you have access to all of these traditional investments plus real estate and even other alternative asset classes.
Because fees and other services may vary, it is a good idea to check out a few of the independent IRA custodians to find the one that fits best with your needs.
Now that you know how to open an account, let’s discuss how to fund the account. In 2016, the IRA and Roth contribution limits are $5,500 or $6,500 for an individual over the age of 50 and making catch up contributions. We all know that $5,000 or $6,000 is not enough to buy rental house, so how else can we fund the IRA?
One very popular way, if eligible, is to roll over your 401(k) plan into a new self-directed IRA or use a self-directed 401(k) that is allowable by both the IRS and the IRA custodian.
In many scenarios, the IRA holder will have sufficient funds to cover the real estate purchase, but what if you find a great investment property for your IRA, something really valuable, and your retirement account simply doesn’t have adequate funds? Luckily, there are a number of ways in which you can make the purchase and still keep the transaction both legal and profitable.
In our next articles in this series, we will review three ways in which you may want to pursue real estate investing with your IRA.
- Tenancy-in-common (TIC)
- Limited liability companies (LLC)
We hope this information is helpful for you and we invite you to read the next article in this interesting series.
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