Buying Real Estate in Your IRA? Not So Fast
Key Points in Buying Real Estate in Your IRA? Not So Fast:
- Basic IRA rules
- Real Estate Taxation
- Inherited Real Estate
- Problems with owning real estate in your IRA
- 5 minute read
There is no shortage of people and companies out there trying to convince you that buying actual real estate in your IRA is a good idea. A quick google search of the term real estate IRA brings up about 63,800,000 results in just under a half a second. Really. I copied the search results and put them below so you could see them for yourself.
The first page of search results contained, almost exclusively, people and companies not only telling you what a good idea it is but also offering to help you do it. I would give you their names, but I don’t want to help them by offering free advertisement to sell a product that, in my opinion, doesn’t make sense and is fraught with IRS peril.
We will discuss those perils and the “advantages” these people and companies tell you come with owning real estate in your IRA, which, in large part, are not advantages at all.
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Buying Real Estate in Your IRA
Links Mentioned in this Episode
Dean Barber: Thanks so much for joining us on America’s Wealth Management Show. I’m your host, Dean Barber, along with Bud Kasper.
Bud’s on Vacation
And Bud, you’re doing a little spring break time down in Florida with the family, left me in the studio all alone.
Bud Kasper: Yes.
Dean Barber: I don’t like this.
Bud Kasper: This is what they refer to as turnabout. For all the times that you’ve done this when I was in the studio and good old KC. Not today. It’s my turn.
Dean Barber: There you go. Well, hopefully, you guys are having a good time.
Investing in Real Estate Inside Your IRA
So today, Bud, we want to talk about the idea of investing in real estate inside of an IRA. And we’re going to get to all the specifics. First of all, you can do it.
Bud Kasper: Sure.
Dean Barber: Bud, you and I have studied now with Ed Slott, and Ed is, by the way, considered one of America’s premier IRA experts, and he just wrote a rewrite of his book, The Retirement Savings Time Bomb, and How to Defuse It. He’s got a brand-new publication out on that just now.
But Bud, in all the time that we have spent over the last, I think it’s close to 15 years now, studying with Ed. He basically says, “Why would you want to put real estate inside your IRA?? And he’s not in favor of it.
Bud Kasper: Yeah, he’s investigated it, and, as a CPA, he knows some of the pitfalls associated with paying taxes on that type of investment. Nonetheless, we all know real estate can be very fortuitous in terms of making a nice money farm in that particular investment.
Dean Barber: Yeah. First of all, let’s both get it out on the table. You and I both own investment real estate. And I think that investment real estate is proper diversification. You should have some real estate, right?
So, there’s nothing wrong with real estate as an investment. In fact, I like it, and so do you. And I have a ton of clients that own investment properties. But they don’t own it inside of their IRA.
Bud Kasper: Exactly.
Reasons You Might Avoid Buying Real Estate in Your IRA
Dean Barber: And there are some pretty specific reasons why you don’t want to do that. Bud, it’s all about the taxes. When you have an IRA, it is a retirement account with all kinds of rules surrounding it.
It’s tax-deferred or tax-free; if you do the Roth, it’s tax-free; if you do the regular IRA, it’s tax-deferred. But on the traditional IRA, if you take money out of that IRA prior to 59 and a half, you’re subject to a 10% penalty unless you follow some very specific rules. There’s a couple of exceptions to that.
But even after retirement, as you take it out after 59 and a half, it’s subject to ordinary income tax. Well, real estate by itself can have some favorable tax treatment. You get some depreciation on that real estate to offset some of the income that it makes.
When you sell it, you get long-term capital gains. There can be some recapture that can go back and recapture that depreciation, and that recapture can be taxed as ordinary income.
Losing Some Tax Benefits
But as of today, as we do this show, unless this new administration does something differently, when you pass the money to the next generation, the next generation gets a step-up in basis. And so they could sell the real estate with zero tax. That could never happen inside of an IRA, Bud.
Bud Kasper: You’re exactly right, Dean. And that becomes the issue. We all want to have high returns, but then again, paying Uncle Sam is the other part of the netting out of what the real profit was for us. From the perspective of what our audience might be thinking about today, you really need to know the rules, and here’s just a few.
Bud Kasper: You need to have a self-directed IRA, any real estate property you buy in your IRA must strictly be for investment purposes. You and your family cannot use it. Purchasing real estate in an IRA almost always requires paying in cash, and by the way, the expenses have to be paid by the IRA.
Paying Cash for Real Estate Purchased in an IRA
Dean Barber: Hey Bud, hold on a second. Hold on a second. Let’s attack one of those things just for a minute. I’m going to talk about the paying in cash piece. Okay.
Bud Kasper: Sure.
Dean Barber: When you buy investment real estate, the way that you can make real estate profitable is by using leverage, i.e., debt.
A Real Estate Example
For example, you take a property that’s going to cost, to make it a simple $500,000. You’re going to put 20% down. So you put $100,000 down on that property. So now, what’s your investment in that $500,000 property? It’s a hundred thousand dollars, right? That’s your investment.
Bud Kasper: Right.
Dean Barber: Now, over time, your renters pay off that note. Once the note is paid off, you can turn that $100,000 into $500,000 or whatever the real estate has appreciated, right? That’s where you get the attractive returns in real estate.
Buying Real Estate with Cash
If you buy real estate with cash, it’s more like you’re buying a bond, right? Because you’re just saying rent will be your income, and 5%, 6%, or 7% net of all of the expenses to keep the real estate up is a good return on real estate.
If you’re thinking about it in terms of that, you almost always have to pay cash for the real estate for purchasing inside the IRA. The reason is that you can’t have a loan on it that you personally guarantee. Otherwise, it disqualifies the IRA, makes it a prohibited transaction causing the whole thing to be taxable.
Understanding the IRA Rules
Bud Kasper: Exactly right. That’s why you have to understand the rules before you enter into a real estate investment inside your IRA account. It can be very tricky, Dean.
The Complexities of Buying Real Estate in Your IRA
Dean Barber: Absolutely can. So my brother Shane, one of the partners here at the firm, wrote an article on buying real estate inside your IRA. When he did a Google search on real estate IRA, the day that he did, at the time he did it, there were 63,800,000 results in 0.45 seconds. So there’s a lot of people that are trying to say, this is a good idea.
Dean Barber: We’re trying to say real estate is a good idea, but be cautious and understand the complexity of the rules of putting your IRA money into real estate.
Dean Barber: Look, if you want to talk about the pros and cons of real estate, or if you want to get a second opinion from a CERTIFIED FINANCIAL PLANNER™ here at Modern Wealth Management.
As a reminder, you can find America’s Wealth Management Show on your favorite podcast app. So you can get out there and listen to all our episodes without commercial interruption.
More Education, Means More Preparation
Dean Barber: Before we get into some details on this, we both agree that real estate can be a good investment. Of course, all investments have some sort of risk, and the question is: If you’re going to buy real estate inside your IRA, how should you do it?
The Dot Com Bubble and Real Estate in Your IRA
Dean Barber: So Bud, this idea of buying real estate in your IRA, I think, really became popular after the Dot Com Bubble. If you think about it, real estate was pretty dang boring back in the nineties, right? Nobody wanted to touch real estate because look at all the money you can make in the stock market. You had dot-com mania going on.
You had the NASDAQ doing a couple of years in a row close to 100%, all these technology funds, the technology stocks, the dot-com stocks. All that came crashing down, and we had almost three years, 2000, 2001, 2002, where we had some pretty tough times there.
With that, Bud, people started thinking, “What else can I invest in that doesn’t carry as much risk as this crazy market?” Because we hadn’t seen, then, a stock market that was that bad since the early ’70s.
The Dot Com Bubble Made it Popular
And so, that’s where this idea of buying real estate inside of your IRA started to become popular, and so they started these self-directed IRAs and saying, “Hey, you can put real estate inside your IRA.” And why did they do that? Because where do most people have most of their money? It’s in their IRAs. Okay.
Bud Kasper: They wanted the tax deferral.
Dean Barber: Yeah. That’s right. I mean, but if you look, Bud, at the typical person who comes into one of our offices and sits down, a lot of them will have some rental properties, but the vast majority of the people we talk to, most of their money is in either their 401(k) or their IRA.
If it’s in the 401(k), it’ll eventually become an IRA. So that’s why this started to become a popular subject. I’ve always shied away from it just because of how stringent the rules are. Let’s take an example here.
An Example of Owning Real Estate in Your IRA
Let’s say that you own a rental property, your IRA owns it, and the heater goes out. So now that house needs a new heater. You can’t take your credit card and go down to Lowe’s or Home Depot or your local hardware store and buy that heater and have it put in.
The IRA has to buy the heater, right? One transaction. If you did that and purchased the heater with funds, not inside the IRA, you’ve created a prohibited transaction, and 100% of your IRA that very day becomes taxable.
Bud Kasper: That’s right.
Dean Barber: It’s just little bitty things like that, Bud, that cause me to step back and say, “Why would I do that?”
Ed Slott’s Take
Bud Kasper: Yeah. And I think most of our audience, who’s been listening to us for years, know Ed Slott’s name and know that he is considered America’s IRA expert. He’s gone in and effectively said, “No, you shouldn’t be doing this in your IRA. It only adds to complications.”
Back to the Dot Com Discussion
I want to go back to the statement you made about the dot-com era, and I think people need to remember. Minus 46% and some change was what we lost during that particular period. And people at this point, instead of going for capital gains and growth, are saying, “Yes, I need some income off of this because I’ve made some nice money, and I want to translate that into more steady money into my pocket.”
The bond market becomes somewhat of the apparent alternative of that. If we bring this up to today with what we’re experiencing in the bond market, we’re getting higher yields. But we’re having some issues right now, as low as they are, to try to come up with something that cash flowed.
Therefore, real estate was the solution, and it could be even today in the form of REITs. This is not what we’re talking about specifically, but REITs is an investment that is essentially all real estate. We usually buy those as investors because of the amount of income and cash flow that they create. But the question is, is this the appropriate time?
Dean Barber: Well, Bud, you’re cracking me up, first of all. You say we have higher bond yields, and we’re sitting, as we speak, at 1.599% on the 10-year treasury. Okay. But you make a valid point. The average investor can look at the market and say, “Man, this thing seems a little frothy.”
You look at some of the professionals, people who know how to measure market valuations, and they’re saying, “We haven’t seen markets this overvalued since 1999, early 2000.” Okay. So we’ve got a couple of parallels.
You’re right. The big difference today is if you go to bonds and the economy takes off, and interest rates go up, your bonds will lose money.
Bud Kasper: Yep, that was my point.
Dean Barber: So, maybe that’s why so many people today are beginning to bring up this subject of, “Should I put real estate inside of my IRA?”
Bud Kasper: I don’t think we disagree about real estate as a viable investment for ourselves, right? But the question is, the rules many times are so strict and complicated. And by the way, in the IRAs that we use in our custodian, they won’t hold them. So you’ve got to go to a special custodian to be able to accomplish that.
Dean Barber: That’s really what this feels like to me, Bud.
“Well, what should I put my money in? Man, if the stock market’s overvalued if we’re expecting interest rates to rise and bonds could fall, what should I invest my money in?”
The reality is, Bud, that’s the question that everybody wants to know. And why are we talking about real estate in an IRA? Because that’s where most people’s money is. That’s where the bulk of their wealth is.
So what can I do with that wealth with an overvalued market and with the threat of rising interest rates? Well, real estate seems to be a viable option. So, how could you do it? Listen to The Guided Retirement Show episode 23, where I interviewed Dr. Randy Anderson.
He has been investing in commercial real estate for decades, and we do it with Dr. Randy Anderson, but in an interval fund.
So that interval fund is like a mutual fund. It’s a little bit different, but it can own private real estate, and it can own publicly-traded REITs, and it’s liquid. Okay. If real estate turns out to not be the place we want to be, we can sell it, and we can do something else with it.
What Does Your Money Need to Do for You?
The question that you really should be asking yourself is, “What does your money need to do for you to accomplish your short, your intermediate, and your long-term financial goals? “
You decide that, and you find that out by using our proprietary system called the Guided Retirement System™, which is designed to, at the end of everything we do, say, “Here’s your Goldilocks portfolio. This is exactly how you should invest for your goals.”
Dean Barber: While you’re here, schedule a complimentary consultation by clicking here. You can visit with us by phone, virtual meeting, or we’re happy to meet in any one of our three locations in Kansas City, either North Kansas City, Lenexa, or Lee’s Summit.
Are there Exceptions to the Cash Rule?
Dean Barber: So, Bud, you mentioned earlier that you almost always have to pay cash. Are there exceptions to that?
Bud Kasper: Not that I’m aware of. I mean, there are always exceptions, and some attorneys will figure out how to make it happen, but I’m not aware of it, Dean.
Dean Barber: Well, we know the one thing is that you can’t personally guarantee a loan on real estate held inside your IRA.
Bud Kasper: Right. I think you have to go back to the statement that you made, and that is, “Is real estate an important ingredient to my overall plan? Is it necessary for me to have the success I want?”
Dean Barber: Definitely.
Owning Real Estate is Good, But Maybe Not in Your IRA
Our listeners know already that you and I are neither in favor of buying real estate with IRA funds. We’re both in favor of owning real estate.
We think that real estate is a good diversifier, but we believe that it’s just too complicated, and there are too many rules when it’s inside the IRA. Minor pitfalls that could trigger the entire IRA to become taxable. So that’s why we don’t recommend it.
The SECURE Act
The SECURE Act is just one more rule that I think could trip somebody up. So the SECURE Act, if you’re not familiar with what does, it requires the beneficiaries of an IRA to pull 100% of the money out of that IRA by the end of the 10th year, following the 10th year of death.
Dean Barber: So somebody passes away here in 2021. By 2031 you have to have a hundred percent of the money out of that IRA. Well, if that IRA owns real estate, what are you going to do? What if you don’t want to sell the property? What if the property is producing good income?
Well, you could pull the real estate out of the IRA and own it outright, but if you did that, you’ve got to pay taxes, and you didn’t realize any cash to pay the taxes. So you’re going to have the money somewhere outside of the IRA to pay the tax on that real estate, or you’re going to be forced to sell the real estate, and it may not be an appropriate time to sell it.
So again, just be cautious if you’re thinking about putting real estate inside your IRA. It might sound appealing, but if you want to own real estate, don’t do it inside your IRA.
Real Estate for Leverage
Bud Kasper: Yeah. Let me just add one final comment to that. And that is, people buy real estate for leveraging purposes.
If you can borrow low on a piece of property that you feel for sure will appreciate over time, whatever timeframe that might be, five years, ten years, whatever the case may be, that’s one of the real advantages that real estate brings to us. And this time around not as attractive and most certainly is not attractive, in my opinion, in an IRA.
Dean Barber: Right. And if you’ve got good solid renters, the renters can pay that debt off. And so that’s where you get the multiplying effect.
Bud Kasper: That’s right. Real estate increases, somebody else is paying the bill. You’re getting a dividend provided by the people occupying your property if rental properties happen to be the type of real estate you’re investing in.
Dean Barber: But leverage can do something on the opposite side of that too, Bud. I think this is an excellent time to bring that up. So we talked about the Dot Com Bubble. We talked about the market’s going down almost 50% over a two and a half year period.
The Great Recession
We talked about people thinking, “Okay, let’s buy some real estate, let’s put that inside our IRA.” That created a real estate bubble that burst in 2008 with the subprime crisis. I think you probably remember that, right? They called it the great recession.
So what happened there? What happened there was too much leverage on real estate.
A Great Recession Example
So let’s use an example. If you had a half a million-dollar property and you could buy that property and only put 5% down. So what’d you put down? $25,000. A 5% move down in the value of that real estate wipes out your entire investment, right?
Bud Kasper: Exactly. Yeah, we had one of the worst situations without a doubt that we’d ever experienced. When people were allowed to borrow money so inexpensively, that changed one of the dynamics associated with real estate. They were able to buy more home than they would’ve been able to buy if the 20% rule was still there, and that’s precisely what happened.
You had people who had often never owned a home before buying substantial homes, and their down payment is only 6%. Sure enough, as things start to change, now they can’t keep the payments up, and now we have foreclosures, and we know it was part of the Great Recession that we experienced.
Zero Down, Interest-Only
Dean Barber: Bud, there was also the zero down interest-only loans, right? Remember, real estate was appreciating at a pretty attractive pace. And so people could put no money down, get an interest-only loan, and that interest-only loan would then balloon in five years.
At the end of five years, people would think, “Well, now I’ll have enough equity inside of the property to refinance to a traditional 30-year fixed mortgage, and I’m going to be good.”
What happened was those balloon payments came around, and they didn’t have any equity. They were upside down. So, they were having to come to closing with a whole bunch of cash. If they didn’t have the cash, they would get foreclosed on, or they were going to have to be forced into a short sale.
Bud Kasper: Yeah. And guess what? The people that loaned them money didn’t want the property. So you had tons of properties, especially down in Arizona and Texas, that were foreclosed on and unoccupied. Of course, we had people that they were, I don’t know what the right word is, squatters inside that property, and then they endure the expense of removing them. It was a difficult period, no doubt about it.
Diversification and Market Valuations
Dean Barber: All right. So let’s end the discussion of real estate inside the IRAs, Bud. I want to switch gears, Bud, to something we talked about earlier. Diversification and market valuations.
And you and I are both big believers in making sure that you have a diversified portfolio, but we’re both also big believers that the markets can ebb-and-flow. You can have certain sectors of the market that are outperforming or doing better than other sectors.
You can overweight, or underweight, as it may be, overweight to the sectors that are doing better and underweight the underperforming sectors. That’s just active management and diversification.
Modern Portfolio Theory
Bud Kasper: Which was part of what was referred to as modern portfolio theory. And in the course of that, though, sometimes we get caught up in what we think are the general rules associated with investing, and then we get something that flies out of the left field, and it changes things up.
We’re experiencing a lot of that right now with what’s happening in the bond market and the action that’s happening in technology, which had such an incredible year last year.
They’re being challenged right now because people are starting to say, Hey, I made a lot of money in tech, and you know what? If I could hold on for that right now and put it in some fixed-income investment, or a nice dividend, or interest income on that, I’d like to do that but guess what? The rates are going up a little bit, but they’re still so darn low that it’s not an attractive investment at this point.
Where Do You Go?
Dean Barber: Right. So the question is, where do you go? And we look pretty much every day at asset class rankings. And what that is, is it just telling us which asset classes are getting the most money, and which are above average performers, which are then below-average performers.
If we go back to July 23, 2020, what was the darling of that decade, that last decade, was large-cap stocks, Bud, and the large-cap was, even up to July 23, 2020, was doing exceptionally well, but it started to rotate.
Diversification and Asset Allocation
So Bud, diversification and asset allocation, those things are big time in the world of financial planning. Still, you arrive at what we call the “Goldilocks portfolio” through a financial planning process that tells you how much money you should have in equities versus fixed income.
What’s the right amount that you should have to control the risk and to achieve the return that you need to accomplish your short, intermediate, and long-term goals.
The large-cap sector of the market that has ruled the market over almost the last decade, Bud, the large-cap growth stocks have done tremendous large-cap value, large-cap blend, basically, the S&P 500 type stocks have carried the market. Still, starting in July 2020, we began to see a little bit of a rotation.
The 60/40 Portfolio?
So the question is, if your portfolio, your “Goldilocks portfolio” says that you should have 60% equities and 40% in fixed income. Does that mean you should buy 60% of the S&P 500 index, some fund that mirrors that index, and 40% of the bond aggregate? Is that what that means.
Bud Kasper: Well, I’ll answer it by saying yes, you could, but is that the best result you’re possibly going to get? And my answer would be, “No. I don’t think so.”
From interviews that I did with a portfolio manager, and I’m going back almost a year now, Dean, he was completely befuddled by the fact that growth dominated the stock market’s returns for such a long time.
Now, for those not initiating what we’re talking about, you can buy growth stocks, buy value stocks, and buy a blend, which is a combination of the two. Value stocks are often the favorite way people like to invest, and the reason I say that is many dividend-paying stocks inside that type of approach to the hopeful capital game exposure.
But value had not played as much a part in the growth of the stock market. It was the growth stocks that were dominating at that particular time. And experts in this area were, I’m going to use that word again, befuddled that we weren’t getting a rotation going back into value stocks, back in June of last year.
I think that was your point that you made, Dean. We started to see that rotation taking place, and it most certainly continues to dominate at this time.
The Market Rotation
Dean Barber: Well, if you go to November 3, 2020, small-cap for the first time in a long time, came up to be a sector that was above average, and large-cap for the first time in a long time, went to be a sector that was below average.
From November 3, 2020, all the way up through March 1, 2021, Bud, the IWM, which is an ETF that mirrors the small-cap blend.
Bud Kasper: Small-caps.
Dean Barber: Yes, it was up by 41.5%, and during that same period, the S&P 500, which is your large-cap blend, was up only 16.4%. And so you have seen that rotation, and today small-cap blend, small-cap value, small-cap growth, mid-cap value, and growth.
Those are all at the top of the charts, as far as what’s above average, and large-cap is now down to the below-average areas.
Dean Barber: So the answer to the question that I asked you earlier, Bud, is should you do 60% S&P 500 and 40% in the bond aggregate? Sometimes that’s the right place to be.
Rebalancing and Reallocating
But if you start to see that other sectors of the market are outperforming the S&P 500, and they’re doing it in a meaningful way, and you can catch this as it’s happening, and not just wait until afterward and go, “Oh my gosh! Look what small-cap has done over the last six months. Why? Should have been there well?”
Yeah, you should have allocated some to small-cap. You should have started to overweight a little bit 60% equity allocation doesn’t mean 60% in the S&P 500. There’s the right allocation for you.
Now, Bud, you and I both know that when you start getting into small-caps, you’re going to have more volatility than you are in large-caps from time to time.
What is the Right Combination?
Bud Kasper: Exactly. Yeah, and this is what we referred to as diversification. I mean, in the stock market, we have small-caps, mid-caps, large-caps we value, and growth. As I said earlier, what’s the right combination?
Well, I’ll go out on the limb and say, “You’re probably never going to get it right.” But that’s the whole point of diversification to have some of these different assets so that when one isn’t doing well, hopefully, the other one is.
Dean Barber: Well, I can tell you this the makeup of equities and the portfolios that I manage Bud today don’t look anything like the makeup of equities held in the portfolio a year ago.
The reason is that you see a change in what’s in your favor. And it’s not that if you just stayed in the S&P 500 that you had done poorly, obviously not. But we want to maximize what we’re doing, right?
Maximize Your Opportunities
We identify that “Goldilocks portfolio” then we can overweight a little bit to small-caps, and we can underweight in the large-caps because that’s what the indicators are telling us to do right now.
Bud Kasper: Sure. And again, as I said, it’s a diversifier. Now, a lot of people say, “Well, I’d love to get that return that I had with the small-caps, but you know what? I’ve owned those things before, and, boy, when they fall, they fall hard.”
That would not be a misstatement. So, you’ve got to be able to measure your risk by doing what?
Taking the total risk of the portfolio and making sure that you’re managing to that particular level of risks that you’re comfortable with as an investor.
What Should I Invest My Money In?
Dean Barber: Well, and once again, Bud, we get the question all the time. “What should I invest my money in? Where should my money be invested right now?”
Well, the answer to that question comes at the end of a lengthy process. That is our Guided Retirement System™, where we identify exactly what your money needs to do for you to accomplish your short, intermediate, and long-term goals.
Once we understand what that is, we build that portfolio designed to get you where you want to go with the least amount of risk possible. And then you make adjustments along the way Bud, you’ve made adjustments to your portfolios over the last 12 months for your clients.
Dean Barber: I’ve made them for my clients. Our other advisors have made it for their clients. So yes, we know what that “Goldilocks portfolio” looks like, but the “Goldilocks portfolio” changes with time depending upon what’s happening in the capital markets and with interest rates, political environment, geopolitical environment, et cetera.
Understand Where You Are Today
Find out where you should invest your money by taking a test drive with our Guided Retirement System™. Schedule that here through a complimentary consultation. You pick the time you can visit with us by phone. We can do a web meeting, or we can meet in person.
Bud’s Heading to the Theme Park
So, Bud, I know you’re excited because as soon as we wrap this up, you’re on to the theme park with the family. Are you going to get on some of those wild rides?
Bud Kasper: Absolutely. Yeah. I hope that the wind’s in my hair.
Dean Barber: There you go. Well, enjoy your time in sunny Florida, Bud. You’ve been listening to America’s Wealth Management Show. I’m Dean Barber, along with Bud Kasper.
Remember to catch America’s Wealth Management Show on your favorite podcast app. Make sure and subscribe to it so that you can get notified every time there’s a new episode out there. We’ll be back with you next week. Same time, same place, be healthy and be safe.
Basic IRA Rules
To begin with, let’s review some basic IRA rules that most people are familiar with, and some rules most people have never heard of, as well as how real estate is taxed when sold or inherited.
That way, we can discuss owning real estate in an IRA with the rules and tax laws top of mind to understand why it may not be all it’s cracked up to be.
IRAs are, first and foremost, tax deferral vehicles. You put money into them before paying taxes on that money, and you get to allow it to grow tax-deferred until you reach the age of 72, at which time Uncle Sam is tired of waiting for you to pay taxes on that money and requires you to start withdrawing money from your IRA.
RMDs – Don’t Miss Them
They call them required minimum distributions (RMDs); the keyword here is required. Those RMDs, like all withdrawals from an IRA, are taxed as ordinary income in the year the withdrawal is made.
If you fail to take a required minimum distribution, the IRS imposes a stiff penalty. That penalty is 50% of the amount that you should have taken. Plus, you still have to take the RMD and pay taxes on that amount and the penalty amount.
Basically, you don’t want to miss an RMD! If you happen to need to make some money out of your IRA before you reach 59-1/2, you also get to pay a 10% early withdrawal penalty on that withdrawal, as well as the income taxes due.
IRAs also are subject to some less well-known rules. The two that apply to this discussion are prohibited transactions and self-dealing. Here’s a brief description from the IRS website on prohibited transactions.
Prohibited transactions in an IRA
Generally, a prohibited transaction in an IRA is any improper use of an IRA account or annuity by the IRA owner, his or her beneficiary or any disqualified person.
Disqualified persons include the IRA owner’s fiduciary and members of his or her family (spouse, ancestor, lineal descendant, and any spouse of a lineal descendant).
The following are examples of possible prohibited transactions with an IRA.
- Borrowing money from it
- Selling property to it
- Using it as security for a loan
- Buying property for personal use (present or future) with IRA funds
Certain people are considered “disqualified people” where an IRA is concerned, meaning they cannot do business or interact with the IRA. The first thing to note here is that YOU are a disqualified person.
The IRS says your IRA should benefit from investments and business activity, not you. Others who are considered disqualified persons are your spouse, your parents, your grandparents, your children, your children’s spouses, your grandchildren, your grandchildren’s spouses, any adopted children, and step-parents who adopted you.
Companies, where you or a disqualified person own more than 50%, are also considered disqualified persons, and the CEO, officers, directors, employees that hold over 10%, and highly compensated employees.
The 50% threshold is also cumulative, meaning that if you own 15% of a company and your children own 40%, you cumulatively own 55%, and that company cannot do business with your IRA. In this context, that would include any real estate that you own in your IRA.
Remember, the IRS says that your IRA should benefit from investments and business, not you.
No disqualified person can directly interact with an IRA investment. If they do, this is considered a prohibited transaction. The IRA is treated as distributed, meaning the entire amount is now considered taxable as ordinary income in the year the prohibited transaction occurred.
To make matters worse, it doesn’t matter what percentage of the IRA that particular investment represented. It ALL becomes taxable.
Think about that for a minute. A $1 million IRA that has a 5% ($50,000) stake in an investment that has a prohibited transaction occur in it becomes taxable at the current income tax rate to the IRA owner and is in addition to any other income the owner had that year.
Simple math tells you that, at the top marginal tax rate in effect today for someone married filing jointly of 37%, a mistake on a $50,000 investment caused a tax hit of $370,000. Hardly worth the risk if you ask me.
Real Estate Taxation
Now that we’ve got a little IRA refresher behind us, let’s look at how real estate is taxed when sold and inherited. Real estate is generally considered a taxable investment.
When you buy a piece of land, a home, or a building, the amount you pay for the property is considered your “cost basis” to determine how much taxes you’ll owe on the property when you sell it.
As long as you hold the property for more than a year (one year and one day), when you sell it, you are taxed on the difference in what you bought it for and what you sold it for at the long-term capital gains rate.
This year, those rates are between 0% and 20% for a couple married filing jointly based on your income. If you have less than $80,000 of income as a couple, you pay zero percent on long-term capital gains.
If you have more than $80,000 but less than $496,600 in income, you pay 15% on long-term capital gains. And, if you have in excess of $496,600 in income, you pay 20% on long-term capital gains.
What that means is there will be a lot of people who have no tax liability on long-term capital gains this year, and the majority of people who have long-term capital gains this year will pay the 15% rate.
Compared to ordinary income tax rates that range from a low of 10% to the high of 37%, paying taxes at the long-term capital gains rate on the sale of property is a pretty sweet tax advantage.
Inheriting Real Estate
But the tax advantages afforded to real estate and other assets like it don’t stop there. Those assets get another significant tax advantage when they are passed down through inheritance. Here’s an example.
A couple buys a piece of land that they like for $100,000. They hold onto it the rest of their lives, and they leave the land to their heirs at their passing. Let’s say, for the sake of this example, that the land that originally cost the couple $100,000 is now worth $500,000.
Step-Up in Basis
Under current tax law, the heirs get what is known as a step-up in basis when they inherit that land, meaning that their “cost basis” for the land is now what it was worth when the second parent passed.
In this case, their cost basis would now be $500,000. That means that the heirs could turn around and sell the property for $500,000 and owe ZERO taxes on that money.
Or, they could do the same thing their parents did and pass it on to their kids too, who would then get another step-up in basis when they inherit it.
But let’s say the heirs hold the property for a couple of years and decide that they want to sell it, and they sell the property for $550,000. They would only owe long-term capital gains taxes on the $50,000 difference between what they sold it for and their cost basis.
And, depending on their income levels at the time, they’ll wind up paying about $4,500 in taxes on a $550,000 gain. Not too shabby. Not too shabby at all.
The First Big Problem with Real Estate in Your IRA
Here’s the first big problem with real estate held in an IRA, and the one I can’t get past. For the example above, none of the tax benefits we just discussed would have been there because the tax rules that govern IRAs are the ones the heirs would have had to live with.
There would have been no step-up in basis. If they sold the property, they would have had to pay ordinary income tax rates on the entire amount of the proceeds when they came out of the IRA, which under current law has to happen within ten years of the original IRA owner’s death.
There is no more stretching an IRA except in very rare circumstances. But that is just the problem you leave behind for your heirs. There’s plenty of problems waiting for while you’re alive when you hold real estate in your IRA. Let’s explore some of those.
Can I Use the Real-Estate if I Own it in My IRA?
I don’t pretend to know what all someone would do with land or real estate they bought with their IRA. I can only speak about what I would do with land or real estate. I’d use it.
If it were land, I’d want to hunt on it, fish on it, ride ATVs on it, and maybe build some cabins or houses. If it were a house or condo, I’d want to go there and spend time wherever that house or condo was.
But if I owned those properties in my IRA, I couldn’t do any of that. Remember the “disqualified persons” from earlier in the article. The IRA owner and their entire immediate family are ALL disqualified persons.
So my family and I literally could not set foot on those properties without triggering a prohibited transaction and causing the entire IRA to be considered distributed and subject to taxes at ordinary income tax rates.
Now, you might be asking, “Is there an IRS agent just sitting around watching taxpayers with real estate in their IRA’s to see if they set foot on or in it?” Probably not. But, are you willing to take that chance?
Real-Estate Tax Payments for Property in Your IRA
Here’s another problem with holding real estate in your IRA. Real estate taxes are due, as you’re all no doubt aware, every year. But if you own real estate in your IRA, you cannot pay those taxes. The IRA has to pay them. It’s not a huge issue, but it could be if your IRA got to the point where it didn’t have enough other funds in it to pay the taxes.
What if it’s a Rental?
What if it was a rental property? Rental real estate requires maintenance, sometimes lots of it. If you own it in your IRA, you can’t do the maintenance on your own property if you’re so inclined, and you can’t pay the maintenance company to do it. The IRA has to do that.
You also can’t rent it out by yourself. There has to be a management company to do that for you. And they need to be paid by the IRA. Again, not always an issue. But when it is, it’s a big one.
Financing Real-Estate in Your IRA
Financing a property held in an IRA is also tricky. All transactions in the IRA must be “arm-length” transactions, meaning the IRA owner can’t either verbally or in writing personally guarantee the loan made to the IRA.
If they do, it is considered a prohibited transaction, and you now know what that means the entire IRA becomes taxable. You can obtain a non-recourse loan, and there are a few companies that offer them, but they are often more difficult to obtain because they don’t offer the lender the protection that a recourse loan does.
But that isn’t the only problem you can face when financing property in your IRA. The income generated by the property, attributable to the portion of the property financed by debt, is subject to a special tax called Unrelated Debt-Financed Income (UDFI).
And, if you’re asking yourself, “Is he saying that my IRA can owe taxes and have to file its own income tax return?” The answer is yes, even if it’s a Roth IRA. Bet none of the folks in my google search at the beginning of this article will tell you that, and I’ll bet some of them don’t even know about it.
Other Taxes Related to Real Estate in Your IRA
There are other taxes that can arise from owning property or a business inside your IRA. It’s called Unrelated Business Income Tax (UBIT). That tax is applied when a tax-exempt (deferred) entity such as an IRA engages in business that isn’t considered by the IRS to be related to its general purpose.
So, for example, an IRA that purchases an ice cream parlor, coffee shop, pizza parlor, or a sports bar. You get the idea. We all love all of these things, but they are not related to the purpose of the IRA, and all the income generated by these businesses held inside an IRA would be subject to the UBIT.
Due to the arms-length rule that can trigger a prohibited transaction, the IRA owner can’t work in any of these businesses, nor should they patronize them. This is just another reason why I wouldn’t own a sports bar in my IRA. However, it might keep me from being my own best customer if I did!
Required Minimum Distributions and Real Estate in Your IRA
Next, there is the issue of Required Minimum Distributions (RMD’s) that must begin from the IRA at the IRA owner’s age of 72. Those amounts are calculated by dividing the year-end value of the IRA by the applicable divisor found in the Uniform Lifetime Table published by the IRS.
That means that any property or business owned in the IRA must be valued every year. The expense to get a valuation completed is an expense of the IRA, and the IRA must cover that expense rather than the IRA owner.
And that brings us to the undeniable reality that real estate, businesses, and other properties are quite illiquid, which poses a problem when it’s time to take the RMD. If that IRA’s only holding is a rental property or a business, and the rent or business income isn’t sufficient to cover the RMD, what are you going to do?
Sell the appliances or the business equipment to make the payment? You can’t pay the RMD out of your pocket. The IRA has to pay it. Remember that if you don’t take your RMD, the penalty is 50% of the amount you should have taken, plus you still have to take it for the year you missed and the current year. Talk about pouring salt on a wound.
There are Many Considerations for Owning Real Estate in Your IRA
I’m not saying that you should never own any real estate in your IRA. There may well be times when it makes sense for a small fraction of the population. Maybe. However, for the overwhelming majority of you out there, it’s just not a good idea.
The proponents of owning real estate in your IRA always tell you that you can own your real estate in a tax-advantaged account, and that’s not untrue. However, what they DON’T tell you is what I just laid out for you in this article.
While IRA’s are tax-advantaged for a while, they become a liability and a potential tax trap later on. And, because the IRS is smarter than most people give them credit for, they’ve made holding real estate in an IRA way more of a headache than it’s worth.
It’s also important to remember that IRAs do not benefit from a step-up in basis when inherited. Every dollar that comes out of an IRA is taxed as ordinary income because the money in the IRA has never been taxed. And Uncle is tired of waiting on his tax money.
The SECURE Act Changed Things Too
Also, non-spouse beneficiaries no longer have the ability to stretch an IRA over their own lifetime. That went away with the SECURE Act.
The SECURE Act also says that the IRA must be emptied within ten years of the IRA owner’s death, ensuring that the entire IRA will be subject to ordinary income taxes within ten years, and, likely at much higher rates than if the stretch were still in place. It’s a win for Uncle Sam and a huge loss for the non-spouse beneficiaries of an IRA.
Take a Step Back and Consider Your Situation
So, if you have been considering using your IRA to purchase a business or real estate of any kind, I implore you to reconsider. Don’t put an asset that comes with a whole host of tax advantages into an account that comes with a whole host of tax disadvantages!
It just doesn’t make financial sense unless, that it is, you happen to be the one making money setting up this tax trap for the unsuspecting.
If you would like to talk about this at greater length, as always, we’re here for you.
Have a wonderful week, and don’t buy anything in your IRA that I wouldn’t.
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The views expressed represent the opinion of Modern Wealth Management an SEC Registered Investment Advisor. Information provided is for illustrative purposes only and does not constitute investment, tax, or legal advice. Modern Wealth Management does not accept any liability for the use of the information discussed. Consult with a qualified financial, legal, or tax professional prior to taking any action.