We all know that you can buy stocks, bonds, mutual funds, ETFs, options and other wall street products within an IRA. Did you know that you can also buy investment real estate within your IRA? Traditional brokerage houses are not set up to do this but by opening a self directed IRA(SDIRA) you are free to invest in just about any investment vehicle you desire.
I have done this myself. When I tell folks, I typically get several questions. Are you sure it is allowed? Why should I buy inside an IRA instead of outside an IRA? Can I get a loan or do I need to pay cash?
Before we get started…..
Note 1: I am not a tax professional or financial planner. This is intended as a general overview of the topic. See the full disclaimer below.
Note 2: I am licensed in Virginia. If this makes sense and you want to invest in Northern Virginia, I would be honored to represent you. However, if you want to invest in another area or even another state, still call me. Through my association with several Realtor investor groups, I can find you an experienced investment oriented Realtor in your desired market. DO NOT just select your favorite neighborhood Realtor for this strategy. It is just too important. You need someone with a solid investment resume.
Okay, let’s go…
DOES THE IRS ALLOW THE PURCHASE OF REAL ESTATE IN AN IRA??
The first question folks often have is whether or not investing in real estate inside a SDIRA is allowed. It is if done properly. Here is an excerpt from the IRS.gov website. The link to the page is here
What types of investments can I make with my IRA?
The law does not permit IRA funds to be invested in life insurance or collectibles.
If you invest your IRA in collectibles, the amount invested is considered distributed in the year invested and you may have to pay a 10% additional tax on early distributions.
Here are some examples of collectibles:
• Metals – with exceptions for certain kinds of bullion,
• Coins – (but there are exceptions for certain coins),
• Alcoholic beverages, and
• Certain other tangible personal property.
Check Publication 590, Individual Retirement Arrangements (IRAs), for more information on collectibles.
IRA trustees are permitted to impose additional restrictions on investments. For example, because of administrative burdens, many IRA trustees do not permit IRA owners to invest IRA funds in real estate. IRA law does not prohibit investing in real estate but trustees are not required to offer real estate as an option. (emphasis added)
So, according to the IRS you can use a SDIRA to invest in real estate. With a SDIRA, you can also lend money to others, invest in businesses or do just about anything you want except for the prohibited transactions above. But since I’m a Realtor, I will focus on the real estate opportunities within a SDIRA.
Inside a SDIRA, you can buy and hold rental property. You can fix and flip. You can speculate on land. You can buy an apartment or commercial building. The mechanics of how this is done may make some of these options a little harder inside an IRA than outside but they can be done.
SHOULD I BUY REAL ESTATE INSIDE OR OUTSIDE AN IRA?
Like any investment, you must identify your goals. Buying inside an IRA is not the right choice for everybody. Here are some common goals and approaches to real estate investment that do not work with an IRA.
1) USING AS A COLLEGE FUND: I have a client who bought 2 rental properties when his daughters were young. The plan was to sell them when they were 18 and use the money to pay for their college. If you will be less than 59 ½ when the money is needed, this may not be the way to go. The same rules that apply to traditional IRA withdraws apply to SDIRA withdraws. If the money is withdrawn before 59 ½ there is a penalty.
2) PERSONALLY PUTTING IN SWEAT EQUITY. I have many clients who enjoy getting their hands dirty and instead of hiring out for repairs to their rentals, they do everything themselves. That is strictly prohibited in a SDIRA real estate investment. IRS regulations are very clear. All repairs maintenance and updates must be done by 3rd party contractors at market rates and paid for by the SDIRA custodian. You can not use your personal funds. Doing work yourself could blow up the IRA and the IRS could consider the whole investment as income to you in the year of the violation. Do not even change a light bulb if the property is in an IRA. While people have done fix and flips in an IRA, one must tread very carefully.
3) RENTING TO FAMILY MEMBERS I have clients who have bought rental property and then rented it out to family members – children, parents, their grandchildren in college, etc. Strictly prohibited. You cannot do business with family members in your direct family line – parents, children, grandchildren. They are considered “disqualified persons.” This also applies to you personally. You cannot “sell” property you currently own outside the IRA to the IRA.
4) BUYING WITH PLANS TO MOVE IN LATER I have had clients decide to sell a rental in Vienna Virginia and exchange it for a beach rental with plans to retire there in a few years. You cannot use the property personally or it becomes a taxable event. The asset will be considered distributed in the year you move in. That will drastically increase your income in that year!! Plus you will incur a penalty if you are not 59 1/2.
So with all of these restrictions why buy in an IRA? I get asked this all the time. “Why not buy outside of the IRA so you can get the depreciation and tax deductions?” My quick answer is because the money is already in the IRA. But this is really a two part question – new money vs old money. (Remember that old Willie Sutton line as to why he robbed banks. He supposedly said, “Because that’s where the money is.”)
If you have $40,000 you wanted to invest in real estate this year, you have a choice – buy outside a SDIRA or contribute that to a SDIRA/SEP and buy the real estate inside the IRA. If the goal of the real estate investment fits into one of the prohibited transactions categories, the answer is simple – outside the IRA. Otherwise it requires careful analysis of your situation and goals.
But what about “old” money? Many people may not have significant money for a real estate investment outside their IRA but do have a sizable IRA. Then it becomes a question of deciding how much you want to diversify your portfolio. What percentage in stock and what percentage in real estate? It is important to keep in mind that real estate is not liquid. Life happens. If you needed to reach into the IRA for an emergency, you can quickly liquidate stocks but not real estate. This becomes even more important when, with a traditional IRA, distributions are required after the age of 70 ½.
THE 3 BEST REASONS TO BUY USING AN IRA –
TAX SAVINGS, MAXIMIZING WEALTH CREATION AND FLEXIBILITY
To me, the biggest reasons to buy inside an IRA are taxes, flexibility and wealth creation. Let’s remember, every property needs to be sold at some point. This is where the SDIRA shines.
1. HUGE TAX SAVINGS WHEN YOU SELL
As you are probably aware, if you sell outside an IRA, you need to pay capital gains tax. Currently capital gains taxes for most people are 15%. But what folks don’t realize is that when you sell you also need to “recapture” all of the depreciation you took on the property over the years and pay tax on that at ordinary income rates. So while you get great tax benefits from your property each year for depreciation, you get killed when you sell.
If you sell inside the IRA, there are no taxes. Think of what happens tax wise when you sell a profitable stock or mutual fund in your IRA which is….nothing, The same with real estate. It is just another investment vehicle inside an IRA
Let’s say you are past 59 ½ and can withdraw money from the IRA without penalty. Let’s say you have a child ready to buy their first home and you would like to give them $25,000 for a down payment. You also decide you no longer want to be a landlord so selling the property helps accomplish both goals.
If the property was outside the IRA, you would be subject to roughly the same taxes as mentioned above. Inside the IRA, the sale is not taxable.
When you withdraw the $25,000, if you are in a traditional IRA you will pay taxes on that $25,000 at ordinary income rates. But your ordinary tax bill on $25,000 is surely a whole lot less than a tax bill on the recaptured depreciation plus the capital gains tax plus the investment tax. (If you had a Roth self directed IRA, even better. The withdraw would not be a taxable event.)
2. MORE MONEY TO REINVEST MEANS GREATER ASSET GROWTH
Let’s say you sell a property you owned for 10 years. You take away from the table $200,000.
Of that $100,000 is capital gain and you have taken $50,000 of depreciation over the 10 years.
You will need to pay $15,000 in capital gains and assuming a 25% tax bracket, $12,500 in recaptured depreciation. (if you have state income tax, add that to the mix.) You may have slightly different percentages depending upon your tax bracket and you may also need to pay the investment tax generated by the affordable care act. That is all beyond me but the point is instead of $200,000 to reinvest in your next project, you will have something like $172,500 +/-.
Sell in an IRA and you have $200,000 for the next project. Huge difference.
Let’s say you are 30 and do this every 10 years. Outside an IRA, you are missing opportunities because you had less capital to reinvest due to the $25,000 or so you paid in taxes after each sale. Not hard to see how wealth builds much faster in an IRA with an extra $100,000 to invest over 30 years.
3. FLEXIBILITY VS A RESTRICTIVE 1031 EXCHANGE AND INCREASED OPTIONS LATER IN LIFE
SELLING IN AN IRA VS A 1031 EXCHANGE
The astute investors among you will say that outside the IRA you can defer taxes on the sale by doing a 1031 exchange. And you are absolutely correct. That is an excellent way to go but there are limitations with that strategy.
First, with a 1031, you must reinvest all proceeds into another piece of real estate.
Inside the IRA you can decide that you prefer to use only a portion of your proceeds to reinvest in real estate. With the rest, you can use some to be an angel investor to a local start up and put the remainder in a very safe index fund.
A big tax bill if you do that outside an IRA. No tax bill inside the IRA. The IRA offers flexibility and options most investors crave.
Second, in a 1031 taxes are deferred. The only way to avoid taxes completely is to hold that piece of real estate until you die and then your heirs inherit it at market value. But do you want to be a landlord in your 80s? Let me tell you a true story about Mr. Wilson. (name changed but the story is true.)
MR. WILSON, THE RELUCTANT LANDLORD
When I moved into my current home, the home next to me was a rental owned by Mr. Wilson. Mr. Wilson was in his 80s and had made quite a bit of money in his lifetime from his construction business and other real estate investments. He did not need the income from the house next to me and, to be honest, if he sold it, the money he would make was not needed either. He was set. He was modest and down to earth – right out of the book The Millionaire Next Door by Thomas Stanley.
Every time the tenant left and Mr. Wilson came by, like Dennis the Menace, I would go over and say “Oh Mr. Wilson……… have you thought of selling the home? Do you still want to be a landlord?” He would say, “I don’t want to be a landlord anymore but I refuse to pay those *&%&#@# capital gain taxes. I’m an old man and I will just keep this until I die and let my kids get it at a stepped up basis. They can do with it as they please. Go away Dennis and let me be.” (He never said that last sentence as he was the kindest man and my name isn’t Dennis.)
Fortunately for Mr. Wilson he continued to live. Unfortunately, he continued to have to deal with landlord issues when he wanted a simpler, hassle free life. Then Mrs. Wilson became ill and he didn’t want to deal with this house anymore. Eventually, his solution was to donate the home to his church and then the church hired me to sell it. A beautiful solution for Mr. Wilson and his church but one that would not work for a less wealthy family.
My point? While we are staying active longer, there comes a time when we want to move on to more relaxed life. Real estate outside an IRA can become a burden. Inside a SDIRA, it is easily sold.
DO I NEED TO PAY CASH OR CAN I GET A MORTGAGE?
You can get a loan to buy rental property inside an IRA. The specific type of loan you need to get is called a non-recourse loan. Non-recourse means that you do not personally guarantee the loan. The SDIRA has the loan. If loan goes into foreclosure, the only recourse the lender has is to take back the property. They cannot come after you personally.
Thus, the beauty of a non-recourse loan is that the approval of the loan has nothing to do with your income or credit and everything to do with the cash flow of the property. The loan application does not ask what you do for a living, how long you’ve been doing it, your annual income or about your assets outside the IRA. The lender needs to verify that the rental income will more than cover the mortgage and that you have enough IRA assets to handle repairs or vacancies. They will run your credit but only if you are a true deadbeat will it become a factor. I asked a loan officer if folks who recently had bankruptcies, foreclosure or short sales could get a non–recourse loan and the answer was, in most cases, yes. Only if there have been several instances of foreclosures or significant financial sloppiness would they look more closely at it.
As you might imagine the rates are a little higher than traditional rates and the max number of years for amortization is 25 but most loans are limited to 20 years and few to 15. Down payments are 30% to 40% minimums depending upon location and type of property.
One downside on a non-recourse loan is that it can trigger unrelated business income tax. (UBIT). This is complicated but UBIT basically means that income generated by debt is subject to tax. So if you borrowed 60% of the value of the home and made $10,000 profit for the year, $6000 of that $10,000 would be subject to tax but you can offset it by depreciation and all of the other items you normally use on a rental property outside the IRA.
There are a few ways to avoid UBIT but that is the subject for another blog and one that I will have written by a tax professional.
DOES THIS MAKE SENSE FOR YOU?
If so, give me a call to further discuss the ins and outs of using a self directed IRA. If after our conversation, you want to move forward, I will advise a consultation with your accountant, an independent financial adviser or other professionals familiar with your financial life.
Then if you want to buy in Northern Virginia, I am here to help. But if it makes sense for you buy outside of Northern Virginia, I urge you to still call me first. You do not want to select any Realtor to help you on this. Again, we are talking about your retirement money. It is important you select a Realtor familiar with investment real estate. I can find you that Realtor in just about any market in the US. I am part of several real estate investment networks and will make sure you are introduced to someone who knows the ins and outs of investing in your selected market.
I have studied this topic extensively and even attended a 3 day workshop in Orlando in September to learn more about real estate inside self directed IRAs. Call me before talking to any other Realtor in any market around the country. I will be happy to give you questions to ask other professionals about this opportunity.
WOW THIS IS A LONG BLOG!
Yes it is. But this is a very important topic and I wanted to take some time to lay out the basics. Over time, I will be writing more and more about this opportunity and will soon have an IRA investing section on the website.
I welcome the comments of any tax professionals or financial advisers who agree or disagree with my comments or who feel some of the statements above are incorrect.
DISCLAIMER: I AM NOT A FINANCIAL PLANNER. I AM NOT AN ATTORNEY. I AM NOT A TAX PROFESSIONAL. I AM A REALTOR. THIS INFORMATION IS INTENDED AS A GENERAL OVERVIEW OF THE TOPIC. YOU ARE STRONGLY ADVISED TO CONSULT WITH FINANCIAL, TAX AND LEGAL PROFESSIONALS BEFORE MOVING FORWARD. YOUR RETIREMENT MONEY IS PRECIOUS AND WE ARE DEALING WITH IRS GUIDELINES. YOU MUST BE CERTAIN THIS IS THE RIGHT PATH FOR YOU AND THE TRANSACTION FOLLOWS IRS RULES. IT MAY BE THAT YOUR SPECIFIC SITUATION IS NOT WELL SUITED FOR A SDIRA. I CANNOT MAKE THAT DETERMINATION. ONLY A FINANCIAL OR LEGAL PROFESSIONAL CAN HELP YOU WITH THAT. IF IT IS THE RIGHT PATH FOR YOU, I STAND BY READY TO HELP YOU GET STARTED