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Should I Put Real Estate in my IRA?

Speculation in real estate is so, well, so 2006.  Wen the bubble burst in 2007, prices adjusted downward, and many real estate “flippers” were stuck with homes and condos that became worth less than their purchase prices.  Buyers gained control of the market.  Theoretically, that was a great time to purchase real estate.

Now, things have changed.  Real estate is gaining value across the country.  At the same time, strong stock market performance has increased our Individual Retirement Account (IRA) balances.  Owning real estate in an IRA seems to be an idea whose time is at hand.  But does it make economic sense?

Several classes of assets may not be purchased in an IRA, but real estate isn’t among the prohibited investments (IRS Publication 590 contains the rules for IRAs).  While IRA real estate ownership may sound good, and is perfectly legal, in most situations real estate investing is better done outside of a tax-deferred retirement account.  There are numerous reasons for this, and I’ll elaborate on what I believe to be the most important deterrents.

Non-standard asset custodians.  IRA accounts are usually held at banks, credit unions, insurance companies, brokerage firms, and mutual fund companies.  Most of these financial firms will not allow direct real estate holdings within accounts in their custody.  This means that you will have to find a specialized custodian, and open a separate IRA account in order to buy real estate.  A recent Google search on “IRA real estate custodians” turned up several potential custodians.  These companies are highly specialized, with administrative costs that tend to be significantly higher than those of traditional IRA custodians.

Prohibition Against Self-Dealing.  You, as an individual, as well as your lineal family members, are prohibited from doing business with your IRA. This is called self-dealing, and the penalty is simple and severe – loss of tax-advantaged status in your IRA, resulting in a large and immediate tax bill for you.  Self-dealing prohibits you from engaging in such actions as occupying any part of the property, guaranteeing a mortgage, selling, renting or buying to or from yourself, or personally realizing any economic or financial advantage.  These prohibitions also apply to your family members.

No Depreciation Deduction.  Many commercial and investment real estate deals do not show a positive cash flow in the absence of tax savings from the depreciation deduction.  Because IRA income is not subject to income taxes until withdrawals are made, depreciation does not apply while the property remains owned in the IRA.  Somewhat offsetting this limitation is the deferral of any taxes on the gain from the sale of the property until the cash is later withdrawn from the IRA.  (Note: raw land is not depreciable in any case, which could make it more interesting for an IRA investor.  However, raw land generates no income, and therefore may not improve overall investment results.)

Potential Cash Flow Problems.  Owning rental property entails being ready to get hit with unexpected expenses.  Some are major, such as a new roof, air conditioner, plumbing, and a host of other perils.  These expenses have to be paid from the IRA in order to avoid the prohibition on self-dealing.  If there is not sufficient cash in the IRA when it is needed, unless you are legally able to make a contribution or a rollover into the account, the tax-deferred status of the entire IRA will be placed in jeopardy.

Lack of Diversification.  Depending on the total of all IRA assets relative to the value of the property being contemplated, a real estate purchase may consume the bulk of the assets in the IRA, leaving the account undiversified.  While there is no guarantee that a non-diversified account will under-perform a diversified account in any given time period, experience dictates that diversification reduces long-term risk and generally produces superior investment results.

Loss of Long-term Capital Gains Treatment.  When an individual owner of real estate sells property owned for at least one year, the gain is taxed as a long-term capital gain.  Currently, the long-term capital gains tax rate is 15% for most investors (less for low-income taxpayers), and depreciation recapture is taxed at 25%.  These tax rates are generally less that the marginal income tax rate of most investors.  Unfortunately, all withdrawals from Traditional IRAs are taxed at ordinary income tax rates.  Selling the property and later withdrawing the cash from the IRA will often result in paying an increased tax rate on the money.  (Note: Since no income taxes are due on later Roth IRA withdrawals, owning real estate in a Roth IRA may be preferable.  However, the other conditions still apply.)

RMD Problems.  When the IRA owner reaches age 70-1/2, the requirement for Required Minimum Distributions (RMDs) begins.  About 4% of the value of the real estate IRA must be distributed to the owner or to a charity in cash.  Unless the property is throwing off cash in excess of what is needed to pay taxes, maintenance and insurance, the owner may have to sell the property, unless there are assets in another IRA owned by the same individual, sufficient to pay the RMDs for both IRAs.  Selling real estate at the wrong time can be costly, and/or difficult-to-impossible, based on market conditions.  Further, annual valuation of the property for RMD purposes may involve costly appraisal fees, which must be paid from the IRA.  IRS is currently cracking down on valuations of these illiquid IRAs.  After all, failure to pay out the RMD results in a 50% penalty tax on the amount not distributed.  That serves as a great incentive for the “Revenuers” to crack down on RMDs.

All that glitters is not gold, and real estate investing is not a “slam-dunk.”  Individual real estate is not liquid, is expensive to own and operate, is time-consuming (whether you’re a “fixer-upper” or a landlord), and is becoming increasingly difficult to insure.  In a vast and easily-accessible market of financial assets, I believe that most people are better off owning real estate personally (you can limit your liability by using a Limited Liability Company, or LLC).  IRA investors should carefully weigh the pros and cons of real estate ownership.  Certified Financial Planners™ have the skills and knowledge to guide you through the complexities of long-term investing.