The use of self-directed IRAs for real estate investing has grown in popularity as investors seek to reduce their tax burdens and increase their rate of return on their investments. The benefits of owning property in an IRA include appreciation in value and tax-deferred growth on rental income and capital gains. Although there are benefits to holding real estate in an IRA, there are some important things to consider. Any missteps in the rules associated with owning real estate in an IRA could mean disqualification of tax-deferred status and immediate taxation.
Here are some important notes regarding real estate held in an IRA:
- The IRA must be self-directed, meaning you have the option to invest however you please.
- The title to the property is held by a custodian for the benefit of the IRA. No, you cannot be the custodian. The custodian is required to manage the investment, any associated paperwork, and making sure all necessary financial reporting is completed. The custodian will charge a fee for the service they provide.
- The real estate must be held for investment purposes. You cannot use the property for personal uses such as a vacation home, a second home, or as an office for your business. You are also not allowed to make the home available to “disqualified” people. This would include your spouse, your parents, grandparents, children, grandchildren, and the list goes on. You also cannot purchase the investment property from any of these disqualified people.
- It may be difficult to acquire a mortgage to purchase the property. You will likely have to pay a large amount in cash making it a non-starter for some. If you do get a loan, there is also unrelated business taxable income (UBTI) to worry about. The UBTI will require the filing of Form 990-T with the IRS. Most people have a hard enough time preparing a Form 1040, so hiring a CPA would be a consideration.
- Since the IRA technically owns the property, you will lose many of the deductions normally claimed on Schedule E of your tax return. These deductions include property taxes, mortgage interest, depreciation, and others. Any losses within the IRA are nondeductible.
- Any expenses of the property will reduce the balance of the IRA and diminish its ability to appreciate in value. If you need to put more funds into the IRA to cover the costs, you are limited to the annual IRA contribution limits. Over contributing to the IRA can lead to penalties
- Any maintenance of the property must be done with IRA funds and cannot be done by the owner of the IRA. If you perform the maintenance, this is considered a self-dealing transaction that triggers an entire distribution of the fair market value of the property as a taxable distribution.
- The rental income or proceeds from the sale of the property are reinvested in the retirement account and can only be withdrawn when you reach retirement age. Flipping houses in an IRA creates trade or business income inside the IRA making it subject to a 35% UBIT rate on profits greater than $1,000.
Owning real estate in a self-directed IRA certainly has its benefits but due to the many rules that must be followed, it may not be for everyone. To summarize, if the rules of the tax code are not strictly followed, the IRA is disqualified from its tax-favored treatment and all funds are immediately taxable. So, if you decide to invest in real estate using a self-directed IRA, proceed with caution.
If you need the help of a CPA who understands real estate taxation, you can call me at (480) 626-5557 or email me at firstname.lastname@example.org.
by David J. Hawks, CPA, EA