Buy Real Estate With Your IRA?

Many investors don’t realize that the long list of investments they can put in their individual retirement account includes real estate.

Tax law lets people put nearly anything in their retirement accounts. Not only is investment in real estate okay, but so are business investments and even gold coins. Life insurance and collectables, however, are ruled out.

Real estate has looked particularly attractive to investors since the dot com collapse. Since then real estate has soared and while the NASDAQ has stalled below half its 2000 peak.

The vehicles offer investors the chance for potentially higher rewards—and risk—than in the typical brokerage house investments. Investors could always get real estate in their retirement portfolio by investing in a publicly traded Real Estate Investment Trust (REIT). But these pooled investments don’t have the high potential for growth a single property might.

One early adopter to the program split an $8,000 piece of commercial land with a friend, figuring it was a parking lot prospect, says Kelli L. Click is vice president of sales and marketing at Sterling Trust Co. in Waco, Tx. Instead it became scarce billboard space that sold for $500,000.

That doesn’t mean putting real estate in your IRA is easy or common. The rules are tricky. You can’t just cash out your IRA to go buy a second home in Wisconsin.

If you run afoul of the IRS rules, you may be in for punishing taxes and fines, including the 10% penalty for an early withdrawal from an IRA on top of income taxes at your usual rate. Then there’s a 15% ding for breaking the rules for these kind of funds.

Here are some of the guidelines:

— You can’t own the property directly yourself. You need to get an independent IRA custodian. Look for someone who advertises as “real estate IRA” or “self-directed IRA,” advises Click. Understand their fee structure. Will they just set up the account? Or also manage the property?

— The IRS will let you purchase virtually any kind of real estate property: raw land, condos, houses, or commercial real estate. Make sure your custodian does the kind of property you’re interested in.

— No matter how good an investment you think it is, your IRA account can’t buy a property that you already own outside the account. And your IRA account can’t buy or sell to certain close family members either.

— If you’re taking out money for the property, it has to be a “non-recourse” loan. That means the property is put up as collateral and if you default, the lender can’t come after you personally, even if the property value fell so much it doesn’t cover the loan amount. The loans can be hard to come by, says Glick, so many investors split the property with friends if they can’t afford it themselves.

— Stay away from the property. Keep an arm’s length physically and financially. The IRS means this to be an investment property, not your office or vacation spot. So, don’t go over to the house and start working on the plumbing, even though you may see it as just protecting your investment. You can’t live there, work there, or vacation there—even if you paid your IRA account rent.

— That goes for your family, too. If you’re thinking you could just rent the house to your mom or have your son-in-law paint it for cheap, the IRS is onto you. They have a specific list of “prohibited persons”—ancestors (you know them as your parents and grandparents), direct descendants and their spouses—and the same rules apply to them.

— Because you’re not allowed to do it, you need to hire people to manage the property, from finding tenants to doing basic maintenance and repairs.

— Make sure that what happens in the IRA account, stays in the IRA account. That means all the IRA account alone pays all fees, expenses and taxes for the property and collects all rents. However, you don’t have to own the whole property. You can split the ownership with someone else—even someone who isn’t holding it as part of an IRACK.

— Because buying a property requires a big upfront cost and then potentially high maintenance costs, this is an investment for someone who already has a lot of money in their IRA.

— Check your overall asset allocation. What is the value of all you own, including your house, any other properties or investments and any bank, stock, bond or mutual fund accounts? Now how much of that is already in real estate?