Q: Most of my money is in my IRA account. I would like to buy a rental property that I have identified as a good deal. Can I buy the real estate in my IRA?
A: I answered this question a few years ago, but with real estate prices depressed, it is a popular again. Here is an update. The IRS won't allow certain investments, such as life insurance, subchapter S company stock, and collectibles, in an IRA. You can own real estate in your IRA but be aware of the rules and follow them carefully. If you don't, the consequences are Draconian.
The IRS will disqualify your IRA account as of the first day of the year in which you violated the rules, making the entire amount in your IRA taxable. And if you are under 59½ you will also pay a 10 percent penalty. Here are some guidelines:
· You can't "Have your cake and eat it too." If you own real estate in your IRA, you and your family members can't use it. You can't live in it or use it as a vacation home.
· You cannot buy the real estate yourself. Your IRA must make the purchase and hold title to the property. Every penny of purchase money, closing costs, and processing fees must come directly from the IRA account.
If you so much as pay the postage for mailing the documents out of your own pocket, you are breaking the rules. Once the IRA owns the property, the same rules apply. All money for improvements, property taxes, insurance, etc. must come from the IRA and not from your pocket.
If you plan to make a down payment with cash from your IRA account and finance the balance, your IRA must borrow the money, not you personally. You cannot guarantee or co-sign the loan.
The loan must be non-recourse, meaning that if the IRA stops making the mortgage payments, the lender cannot lay claim to other IRA assets.
It may be difficult to get a mortgage under these conditions. If the IRA is successful at borrowing the money to make the purchase, all income from the leveraged portion of the property is taxable to the IRA at trust tax rates, which can be significantly higher than individual tax rates. For example, if your IRA borrows 70 percent of the purchase price, then the IRA will pay tax on 70 percent of the net income. That defeats one of the main reasons for having an IRA, which is tax-deferred growth.
· Your IRA cannot purchase real estate from you or a family member or an entity that you own.
· When you sell real estate for a profit, at least some of the gain is usually taxed at more favorable capital gains rates. But if an IRA sells real estate, all the profit is taxed at higher ordinary income tax rates upon withdrawal. Tax-wise it makes more sense to own real estate out of, not in, a retirement account.
· Most IRA custodians, like banks and brokerage firms, won't allow you to purchase real estate in your IRA. However, there are trust companies that specialize in IRAs that hold alternative assets such as real estate. They are easy to find if you search for them on the Internet.
Kenneth B. Petersen is an investment adviser and principal of Monterey Private Wealth, Inc., in Monterey. Send questions concerning investing, retirement or estate planning to 2340 Garden Road, Suite 202, Monterey 93940 or firstname.lastname@example.org.