Ask an Expert: Are Real Estate IRAs a Scam?

My real estate agent has been telling me I can use IRA money to buy a small apartment building. It’s a solid investment, but can I use IRA money to buy it? I would have to mortgage about half of it, but I thought it was illegal to borrow money using an IRA. I don’t want to make a mistake and pay a penalty to the IRS for using my IRA improperly. Am I missing something?

–Hayden, Monrovia, California

Dear Hayden,

If it’s an investment you want to make, then I have good news: It is quite possible to take direct ownership of real estate within an IRA. In fact, there are people across the country who are doing just that, using a strategy called ‘self-direction.’

Here’s how it works:
All of us are familiar with IRAs that own stocks, mutual funds, money markets, and other paper assets. But the IRA platform, as defined in the Employee Retirement Security Act of 1974, actually allows you to hold almost anything you want in your IRA, including real estate. In fact, the only asset classes that are closed to you within an IRA are life insurance, gems, jewelry, collectibles, alcoholic beverages, and certain kinds of gold and bullion of insufficient or inconsistent purity.

Outside of that, all that is not forbidden is permissible. So, yes, you can indeed take direct ownership of rental real estate within an IRA, including an apartment building of any size you can afford.

Real estate IRAs have some tax ramifications, of course:

  • Rental income is generally tax deferred
  • No capital gains are due when you sell property held in an IRA
  • You can’t take a depreciation expense
  • You can’t take a deduction on interest income (since it’s not taxed in the current year within an IRA)
  • You can’t deduct repairs (since rental income isn’t taxable, there’s nothing to deduct against)

You can also hold real estate within a Roth IRA, in which case the rental income is generally tax-free, as is capital growth.

Mortgages Within IRAs

It’s also quite possible for your IRA to borrow money in the form of a mortgage. However, there’s an important caveat: It’s your IRA borrowing the money, not you personally. You cannot sign a personal guarantee, and the only allowable collateral must come from within the IRA itself. The loan must be on a non-recourse basis. That is, if the loan goes into default, the lender must not have any recourse against you. They can only foreclose on the collateral, which must be from within the IRA.

There are a few finance companies that specialize in this kind of lending. It’s all underwritten based on the value of the asset. Most won’t lend more than 65 percent on a property–less if the property is out of state, is located in certain states, or is otherwise considered high risk.

Entities

Just as most real estate investors wisely hold their properties in separate entities outside of an IRA, you can also own entities within the IRA. In fact, it’s probably a good idea to hold each property within its own C corporation or LLC (IRAs can’t own S corporations). That way, if a tenant sues your property, they can’t collect on the rest of the IRA–only property within the IRA.

Note that when you draw up the title and other ownership documents, it’s critical that they do not list you personally as the owner. They should say, ‘IRA, for the benefit of John Q. Public’ or similar language.

Beware of UDIT

Note that if you do choose to own real estate within an IRA or a Roth IRA, then you will become subject to a little-known special tax called the ‘unrelated debt-financed income tax,’ or alternatively, the ‘unrelated business income tax.’

In a nutshell, assets you buy with your own money in an IRA get the benefit of tax deferral or tax-free growth–but not assets that you buy with other people’s money. So if you have a mortgage out for 50 percent of the value of the property, then 50 percent of the income from that property and 50 percent of the gains (if you sell it that particular year) is taxable.

To avoid UDIT, consider owning your property within a self-directed solo 401(k) account. A quirk in the law exempts 401(k) plans from UDIT/UBIT.

Be Aware of Prohibited Transactions

Other than contributions and distributions, your IRA cannot do business directly with you, your spouse, or your descendants or ascendants (parents and grandparents); nor can it do business directly with any entity they control. Furthermore, it cannot transact directly with anyone who advises you on your IRA in a fiduciary capacity.

That means you can’t use your IRA to buy your vacation house, nor can you stay in the property your IRA owns–even if you pay a market rent.

You cannot personally lend money to your IRA–and though your IRA can lend money to others, neither you nor anyone else on that prohibited list can borrow money from it.

You cannot hire yourself, your child, your spouse, or your mother-in-law as property manager–that would violate the prohibited transaction rule. However, you can hire your cousin or your brother.

You must also fund all repairs, marketing, renovations, staff, and other expenses from within the IRA, or with a non-recourse loan. Your new contributions, though, are limited to $5500 per year (plus another $1000 if you are over age 50) or whatever you can roll over into the account. So make sure you have a plan to replace that roof when it goes, without running into a cash crunch.

First Steps

If you decide that you want to go ahead and begin self-directed IRA investing and buy a property, the first thing to do is find the property.

Next, find an IRA custodian or third-party administrator with specific experience in self-directed IRAs or real estate IRAs, and open up an IRA account with them.

Third, execute a rollover by transferring funds from your existing conventional IRA into your new self-directed IRA.

Direct your custodian or third-party administrator in writing to purchase the property on your behalf.

Confirm that the transaction went through and the title is correctly written.

Is It for You?

That said, is investing in real estate using your retirement money for everyone? No. Many times, individuals already have healthy exposure to real estate just from owning their own home and a couple of rental properties. So if you are an experienced real estate investor, by all means, carry on; but be sure to understand how real estate IRAs work in your overall portfolio.

Writing about personal finance and investments since 1999, Jason Van Steenwyk started as a reporter with Mutual Funds Magazine and served as editor of Investors’ Digest. He now publishes feature articles in many publications including Annuity Selling Guide, Bankrate.com, and more.