Real estate a real IRA option: for those afraid of the stock market or unhappy with rates of return on savings accounts, real estate is a little-known alternative source for IRA investment.

Despite the attention, including articles in BusinessWeek (Nov. 18, 2002; Aug. 2003), The Wall Street Journal (Dec 18, 2002; Jan 15, 2003) and other publications, many investors still do not realize they can invest their retirement plans in real estate.

Many feel "trapped" in their stock market investments due to common misconceptions about the types of investments that are permitted within Individual Retirement Accounts (IRAs) and other retirement plans.

It's All About the Custodian

The widespread misconception that permissible IRA investments are limited to stocks, bonds, mutual funds and certificates of deposit (CDs) is a result of people and companies who are in the business of selling these products.

The Internal Revenue Service (IRS) requires that investors have an approved custodian for their IRA or other retirement plan. The IRA custodian for the vast majority of investors is a bank, brokerage firm or mutual fund company--the companies who are in the business of selling investment products. These custodians simply choose to limit IRA investment choices to the products they sell.

The common misconception is that the IRS places these limits on IRA investors, which is not the case. The only investment types that are prohibited by the IRS rules are life insurance and collectibles, such as artwork and antiques. The IRS allows people to invest their IRAs in real estate, lend IRAs as a mortgage loan and many other investment alternatives, as long as an investor has an IRA custodian who is willing to allow these investments.

Getting Started

Once an investor has identified a self-directed custodian or administrator, the process is simple. First, establish the account and transfer or rollover funds from existing retirement plans.

Next, do what rental owners do best: Find a piece of real estate or other investment to purchase in the IRA.

Finally, direct the IRA administrator to purchase the property within an IRA account. This final point is essential and is what allows an investor to avoid or defer paying taxes on all of the income and gains on the property. Investors are not taking a taxable distribution from the IRA; they are simply making an investment within the IRA, just as they would with a mutual fund. All of the income from the investment goes back into the IRA, and all of the expenses of the property are paid from the IRA, all without any taxes.

Prohibited Transactions

The opportunity to invest tax-deferred, or even tax-free, through a retirement plan comes with some restrictions. The purpose of these accounts is to save for retirement, not to use them for a current benefit. A "current benefit" would include using a property owned by the IRA as a vacation or second home, which is prohibited.

In addition, it is prohibited for the IRA to buy property from, sell or lease property to, or extend a loan to the investor or any disqualified person. Disqualified persons include the investor, his or her children, parents, spouse and any business or trust owned or controlled by these people.

So, a person may invest the IRA into real estate as long as the IRA doesn't buy from the investor, spouse, children, parents, etc.

Capitalizing on Self-Directed IRAs 

Even if a rental owner does not have a self-directed IRA, he or she can use this powerful concept as a source of capital for investments.

Many people are earning very little in their IRA accounts because they are scared of the stock market and have invested in low-yielding money markets or CDs. On a five-year CD, they may only be getting 4 percent.

A willing rental owner could pay more than 4 percent to an individual who lent them funds from an IRA for real estate investing. This loan from their IRA could be secured by a mortgage on the property or could be an unsecured loan if the IRA owner is agreeable. The IRA owner increases his or her yield and the rental owner gets funding--a win-win situation. This funding could come from one IRA or several IRks pooled together.

Options and Control

Self-direction is not about higher returns in an IRA, although it may lead to that result. Self-direction is about taking control of investments. With a self-directed IRA, investment options are expanded to include the things that rental owners know and understand. To find a self-directed IRA administrator, visit www.IRAPLUS.com.

Jack M. Callahan, J.D., CFP, is an Attorney, a Certified Financial Planner and Managing Member of Entrust of Tampa Bay LLC, a self-directed IRA administrator. He spoke at the 2005 NAA Education Conference & Exposition as a panelist during the Independent Rental Owners Forum. Callahan can be reached at 800/425-0653 or [e-mail].