We get plenty of calls asking about whether real estate is a good IRA investment. We believe agents should continue to encourage clients to invest IRA funds in traditional investments. Here are some arguments in support of that position.
Real Estate Investments Usually Require Substantial Fees
Many clients hold the mistaken belief that after the real estate is purchased with IRA money, it will be owned and managed much like any other personally owned property. This could not be further from truth! Real estate as an IRA investment must be owned and managed by a professional fiduciary for the benefit of the IRA owner. The fiduciary will charge significant fees for acting as custodian or trustee.
Next, who will solicit tenants, collect rent, evict non-paying tenants, answer complaints, make sure repairs are made and pay all expenses associated with the property? In all likelihood, the fiduciary will insist a professional management company be retained – increasing the cost.
And finally, it should be kept in mind that any purchase or sale of the property will probably require the services of a real estate broker who will want to be paid a commission.
The Prohibited Transaction Rules Must be Strictly Observed
Another common misconception is that property can be purchased in order to provide a residence or vacation home for the IRA owner, children, or grandchildren. Or, alternatively, commercial property can be purchased for use by the IRA owner’s business.
The prohibited transaction rules and rules against self-dealing mean a property cannot be purchased from the IRA owner or family member. Further, once purchased, it cannot be used to benefit the IRA owner or family member. The investment must be a strictly arms-length transaction not involving the IRA owner or family member.
Real Estate inside an IRA Loses Most of the Tax Advantages Generated by Personal Ownership
Many people purchase real estate for the large tax deductions generated in early years. If real estate is owned personally or by a partnership, LLC, or S corporation, many expenses associated with the property can be written off on the individual’s personal tax return. Examples of expenses that can be written off are cost of acquisition, accelerated depreciation and depletion allowance, property taxes, and mortgage interest. Of course, none of this is possible if the property is owned by an IRA.
Leveraging of the investment through borrowing is impractical. Because of IRA rules, the IRA owner cannot personally guarantee debt secured by the property which may preclude borrowing. Even if it is possible to use the IRA funds as a down-payment on a mortgaged property, this may cause any profit on the IRA to be taxed under the unfavorable unrelated business taxable income (UBTI) rules.
Next, suppose a real estate investment is successful in the sense that it dramatically increases in value over the years. If the property is sold to provide income for the IRA owner’s retirement, the distributions will be taxed as ordinary income rather than as capital gains as would be the case for personally owned real estate.
Finally, if the IRA owner dies, the property will be sold and taxed to the beneficiaries as ordinary income. Contrast this with personally owned real estate that would get a step-up in basis at the owner’s death and go to the heirs income tax free.