Should you invest your IRA in real estate?

The volatile, unpredictable stock market has inspired many people to seek alternative investments for their retirement funds. One option that is attracting a lot of interest is real estate. In many parts of the country, real estate may offer higher, more stable returns than traditional investments in stocks, bonds, and mutual funds.

While investing your IRA funds in real estate offers many potential benefits, the rules are complex and the penalties for noncompliance can be severe. Whatever you decide to do, be sure to obtain professional advice to avoid unpleasant tax and costly surprises.

Many Happy Returns

Investing your IRA in real estate not only offers potentially higher returns, but in most cases taxes on the property's income and appreciation are deferred until you start taking withdrawals. You can even sell the property and buy replacement property without taking a capital gains tax hit (although, as discussed below, your gain may eventually be subject to ordinary income taxes).

If you have a Roth IRA, the income and appreciation may escape taxation altogether. Roth IRAs are funded with nondeductible contributions, but withdrawals are tax-free, provided you hold the account until you reach age 59 1/2 (or die or become disabled) and meet certain other requirements. Also, unlike traditional IRAs, Roth IRAs are not subject to minimum distribution rules that require you to start taking withdrawals at age 70 1/2.

Complications

The rules governing IRA investments in real estate are far more complex than those that apply to more traditional investments. First of all, if your current custodian doesn't permit you to invest in real estate, you'll need to move the funds into a self-directed IRA that allows it. Most custodians do not like to hold non-traditional (other than stocks and bonds) assets.

Next, you need to worry about unrelated business income tax (UBIT). Ordinarily, rental income earned in an IRA is not currently taxable. But if the real estate is financed by a mortgage, some of the income may be considered unrelated business income. That means your IRA will have to file annual returns with the IRS and pay UBIT on some of its income at ordinary income tax rates. The best way to avoid this is to have the IRA pay cash for the property, but then you lose the ability to leverage the real estate purchase.

The prohibited transaction rules are another big concern. These rules limit the ability of IRAs to engage in transactions with their owners or beneficiaries. For example, you're not permitted to sell property or lend money to your IRA, guarantee a loan to your IRA, pledge IRA assets as security for a loan, or provide goods or services to your IRA. Also, you can't use your IRA to buy a vacation home or other property for the personal enjoyment of you or your family.

The prohibited transaction rules create some obstacles for investors in commercial or residential real estate. You won't be able to provide management services, for example, either personally, through a family member, or a company that you control. That means you'll have to hire an independent property management firm. Also, the IRA must have sufficient liquid assets to cover operating expenses and other costs--you won't be able to pay them personally.

The penalty for violating these rules can be harsh: Taxes and penalties on the entire IRA balance, regardless of the size of the prohibited transaction.

Tax Considerations

Investing your IRA in real estate offers several potential tax benefits, but there are many tax disadvantages as well. You'll lose the benefit of depreciation and other deductions, for example, and if you have a traditional IRA, the gain on any property sales will ultimately be taxed as ordinary income instead of as a capital gain. Also, with a traditional IRA, you'll need to be sure you have sufficient liquidity to make required minimum distributions once you reach age 70 1/2.

Weigh Your Options

Using a traditional or Roth IRA to invest in commercial or residential real estate can provide significant benefits, provided you plan carefully and understand the risks and limitations. To determine whether this strategy makes sense for you, work with your advisors to weigh the expected tax benefits against the potential tax costs.

BY MARC WIEDER, CPA 

ANCHIN, BLOCK & ANCHIN LLP