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Unlock Your IRA

This article was published in the December 2007 issue of Tallahassee Realtor Magazine. It explains how real estate can be purchased for an IRA/401(k) through a self-directed plan.

By: Patrick Hagen

Talahassee Realtor

Have your clients ever asked about using IRA or 401(k) funds to purchase investment real estate?

Real estate has always been an investment option for retirement plans; however, many investors do not recognize real estate as an option for their IRA. This common misconception is a result of the fact that most IRA brokerage companies and banks do not allow investors to hold real estate and other alternative assets. Brokerage companies sell products (securities, mutual funds, annuities, etc.) and therefore they limit your investment options to what they are licensed to buy and sell. To hold real estate through your IRA you have to use a custodian that offers truly self-directed accounts and does not work on commission or give financial advice.

The main benefit of investing through an IRA is the tax-deferred or tax-free growth. The individual investments made within the IRA are not taxed. Therefore, if you buy a property that has income (rent) or a property that appreciates over time, you will not have to pay taxes on those gains. You can use the money you would have paid in taxes to continue to grow your IRA. Taxes are paid only when you take a distribution at retirement age (unless your account is a Roth IRA; then, distributions are tax free).

All types of real estate can be held in an IRA account. Popular investments include: raw land, rental condominiums, houses, and tenants-in-common interests. Other investment options available for self-directed retirement accounts include lending money with an IRA, investing in a private LLC, and buying stock in a privately held company.

Any type of retirement plan can be self-directed. The most common type of IRA is the traditional IRA. A common choice among self-employed persons is the SEP IRA. SEP IRA plans allow self-employed individuals to contribute 25% of their wages up to a maximum of $45,000 to their IRA each year. The type of account with the most tax benefits is the Roth IRA. The Roth IRA allows the investor to not only grow their account tax-free, but distributions from a Roth IRA are also tax-free. The Roth IRA account holder does not receive a deduction in the year they make a contribution to their IRA, but because they pay income tax on the money when it goes into the account, they will not have to pay taxes when it comes out of the account.

Here is an example of a real estate transaction within a Roth IRA:

John Smith finds an under-priced home in a good rental area. The listing price of the home is $190,000. John has roughly $220,000 in a Roth IRA with his current IRA custodian. He decides he wants to purchase the home through his IRA so that all rental income and appreciation will be tax-free. He sets up an account with a company that administers self-directed retirement plans and then initiates a transfer of funds from the IRA with his current custodian to his new, self-directed IRA. He is not taxed or penalized for the transfer; he is simply shifting IRA funds from one company to another. He doesn’t have to move all of his funds, just the portion that he needs for this transaction.

Per his instruction, his self-directed IRA custodian purchases the property in the name of John’s IRA. Title is issued to: Custodian FBO John Smith IRA#12345. As monthly rent checks come in they flow back to the IRA, tax-free. If John decides later to sell the property, he will not pay capital gains on the appreciation. All of the money will go back to his IRA, completely tax-free.

There are rules surrounding IRA investments in real estate. Section 4975 of the IRS Code addresses prohibited transactions. The main focus of Section 4975 is self-dealing. In a nutshell, the self-dealing rule states that you (and your direct lineal relatives) cannot do business with your IRA. For example, you cannot sell a property that you currently own to your IRA. The investments made for your IRA have to be with an unrelated third party.

Additionally, you are not allowed to use a property that your IRA owns. If your IRA buys a property, that property has to be held strictly as an investment. You personally should not benefit directly from an investment that your IRA owns.

As long as you are doing business with unrelated persons, you can buy and sell as often as you like and none of the investments are taxable while the funds remain in the IRA. Most individuals that purchase real estate with their retirement funds do it for diversification purposes. Generally, investors keep some funds in their brokerage account (stocks, bonds, mutual funds, etc.) and they use a portion of their funds to purchase investment real estate.

Any financial planner will tell you that it is important to diversify your funds to avoid risk; however, most companies only allow their investors to diversify with the realm of the product that they offer. Real estate is an essential element to a diversified portfolio. Self-directed plans allow the investor to be truly diversified.

Reach Patrick Hagen at Entrust Gulf Coast by calling (352) 378-7833 or (800) 483-1629.

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