Investing in Real Estate within Retirement Accounts
As our nation’s population continues to age, baby boomers continue to retire, and as the younger generations are questioning whether they can rely on Social Security in retirement, there is an increasing number of savers looking for alternative ways to save and grow their retirement nest eggs. The government has provided a tax advantaged vehicle for taxpayers to move their retirement funds into investments outside the norm of mutual funds, ETFs, stocks and bonds and into less traditional retirement account investments including real estate, precious metals and debt notes through the use of a self-directed Individual Retirement Account (IRA). Real estate held outside of retirement accounts has long been a staple of retirement planning, but many taxpayers don’t realize they also might be able to do the same within their retirement accounts. As you will see below, there are many potential disadvantages, but for taxpayers with specific goals and circumstances it can present an opportunity.
There are a number of potential upsides to using your retirement funds to invest in real estate, from tax and other standpoints. For many Americans the largest assets they hold besides their homes are their retirement savings accounts, and they may not have the liquidity available to invest in real estate outside of those accounts. For taxpayers who are primarily looking to invest in real estate for retirement savings, their retirement accounts could provide a way for them to either get started, or to continue their investing. The self-directed IRA can even be used as a source of funds to invest in a real estate project with select non-disqualified persons, which would include people other than the IRA owners’ grandparents, parents, spouse, children, grandchildren, and spouses of all of those individuals. This means that a taxpayer could potentially use retirement funds to partner with a sibling or friend to invest in real estate, or to make a loan to those parties through the self-directed IRA. Investing in real estate through a self-directed IRA may also allow a taxpayer to invest in what he or she knows and understands, and to invest locally. This contrasts with investing in the stock market where taxpayers often do not have an intimate knowledge of the companies and industries in which they are investing.
Using a self-directed IRA to invest in real estate also has some tax advantages (but see below for a discussion of some of the disadvantages). The rental income earned by the property and capital gains on the future sale of that property would all continue to accumulate tax free (with some exceptions discussed below) within the retirement account, with the tax paid only upon the disbursement of those funds from a traditional IRA, and distributed tax free in the case of Roth IRAs.
Pitfalls and disadvantages
It will come as no surprise that in order to take advantage of these benefits there are a number of pitfalls that need to be avoided, and disadvantages to be considered. These include restrictions on management and use, illiquidity of the assets, tax rates of the distributions, and tax disadvantages of using debt leverage.
The IRS has strict rules on the management and use of any real estate purchased through a self-directed IRA in order to prevent abuse. These are known as the “prohibited transaction” rules. There cannot be any personal benefit for the IRA owner or his or her family, such as use of a vacation home, self-rental, or allowing family members to use the property. The taxpayer is also restricted from self-managing the property or creating any kind of sweat equity – even the smallest repair completed directly by the taxpayer could trigger a violation of this restriction. If there is a prohibited transaction, then the entire amount invested in the real estate project could be reclassified as a distribution as of January 1 of the year of the transaction, resulting in potential early distribution penalties, income taxes on the distribution, and late payment interest and penalties on those tax payments. The management restrictions of the real estate project held within a self-directed IRA would also prevent the taxpayer from lending or contributing funds to the IRA (outside of normal IRA contribution limits) in order to offset any operating cash shortfalls, meaning the project should be entirely self-sufficient.
Real estate is inherently an illiquid asset – even in a hot market it can take weeks or months to liquidate an investment when cash is needed. For day to day operations this won’t be a consideration for most taxpayers, but once one starts taking distributions the illiquidity of these assets could be a problem. The illiquidity issue becomes a much more significant problem once the IRA owners turn 70 ½ and IRS rules require them to make required minimum distributions (RMD) based on the fair market value of the IRA. If the self-directed IRA does not have ample cash to make the RMD, the real estate may need to be sold in order to fund the distribution and avoid the up to 50% penalty on the distribution shortfall. The other issue this illiquidity creates in regards to RMDs is that on an annual basis the property would need to be appraised in order to properly calculate the required distribution – an additional administrative fee and step. The lack of liquidity and additional administrative issues should be addressed by careful planning and coordination with a taxpayer’s advisors.
When investing in real estate through traditional means, there are several tax advantages, primarily depreciation of the property commonly resulting in cash flows in excess of taxable income, and capital gains treatment upon the eventual sale of that property. Within a self-directed IRA the investment is growing tax free, so neither of these benefits are realized. At a future point in time when the property is liquidated and funds distributed from the traditional IRA, all accumulated rental income and what would have been capital gain income are taxed at ordinary tax rates up to 37%. If the investment was held outside of the retirement account rental income may have been partially reduced by depreciation, and the capital gains on a sale would have been taxed at a lower rate.
For many investors, the appeal of investing in real estate is that they can leverage their funds using debt to invest in a larger property than they could have using cash only, thus resulting in an increased cash on cash return for their investment. Taxpayers can utilize debt within a self-directed IRA to achieve the same goals, but there are a few hurdles that need to be considered. The first consideration is that the debt must be non-recourse, meaning it is entirely secured by the property with no guarantees by the account holder or any of the other assets of the IRA. When debt is used in a self-directed IRA it can result in UBIT (Unrelated Business Income Tax) from the income that is deemed to have been earned via debt financing. The Unrelated Debt Financed Income is calculated annually based on the leverage ratio of the property, and this income would be subject to income tax rates up to 37% once the taxable income exceeds $12,750 (for 2019). Significantly – this Unrelated Debt Financed Income (UDFI) subject to UBIT would also apply to capital gains on the sale of leveraged property. Note that UDFI does not apply to self-directed 401(k) plans. For taxpayers not already in a high marginal tax bracket, the UBIT could quickly erase any benefit of the income accumulating in the account tax free.
While the potential disadvantages of utilizing a self-directed IRA to invest in real estate are numerous, for some taxpayers the need to access the funds within the IRA and the tax advantage of deferral of income recognition will outweigh the pitfalls. Be sure to work with your accountant and retirement advisors to ensure you are familiar with and taking advantage of the rules, while avoiding the potential traps.
If you have any questions regarding investing in real estate with retirement funds, please contact Kory Reynolds or your BNN tax advisor at 800.244.7444.
Disclaimer of Liability: This publication is intended to provide general information to our clients and friends. It does not constitute accounting, tax, investment, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.