Pros and Cons on Holding Real Estate in an IRA

In our previous blog post on using IRA money to invest in real estate, I discussed the steps and requirements to setting up your IRA so that it could invest in real estate.  This blog will go into more detail on the pros and cons of holding real estate in an IRA.  While this listing is not all inclusive, it’s important to know that every situation is unique and requires a complete analysis of the facts at hand.

Below are a few pros to consider that might be the reason(s) you are interested in learning more about this topic and might even be one of the reasons why you have considered investing in real estate through your IRA.

  • Most IRA custodians restrict IRA investments to stocks and bonds, so holding a self-direct IRA invested in real estate may appeal to you for the diversification of your portfolio.
  • If you were already considering purchasing property to invest in, this may be another avenue for funding during a time when housing prices are relatively low.
  • There is the potential for tax-free growth, if held the real estate is held in a Roth self- directed IRA.
  • Already considering purchasing investment real estate?  Investing through a self-directed IRA may be an alternative to having to withdraw the funds early to use the cash for investing in real estate.  Early withdrawals for the cash would require immediate taxation of the distribution along with a 10% penalty, depending on the taxpayer’s age.

Despite the fact that there are advantages to holding real estate in an IRA, the cons tend to outweigh the pros, as you will see with the following.

  • Taxable distributions from a traditional IRA are 100 percent ordinary income, even when the underlying transaction, such as the sale of land, generates capital gain if held outside of the IRA. Therefore, it may be expensive to pay trustee fees and hard to find trustees that will manage it.
  • There are multiple prohibited transactions, that could result in complete taxation of the IRA (including penalties).  The most commonly offended is personal use or self-dealing.  IRA owners cannot use the property for personal or business use, nor can their spouses, children, or parents.  This means no personal vacation homes, renting to relatives, or “flipping” homes by the IRA owner.
  • You cannot co-mingle IRA and non-retirement funds when holding real estate in your IRA.  Therefore, cash flow may become an issue for covering any of costs related to owning the property such as real estate taxes, appraisals and other expenses that must be made solely from the IRA and not with out-of-pocket, non-retirement funds.  Besides having the cash to cover the costs, required minimum distributions (RMD’s) down the road should also be considered.  Limited cash inflow and liquid assets can make this difficult.
  • There is always the potential for unrelated business taxable income (UBTI).  Generally, dividends, interest, annuities, royalties, most rents from real property, and gains and losses from the sale of property are excluded from UBTI; nonetheless, income your IRA earns on leveraged property will be considered UBTI and is taxed at individual tax rates.  In addition, the tax must be paid by your IRA.
  • The custodian or trustee of an IRA must be a financial institution (i.e. bank); however, most banks refuse to allow any IRAs for which they are custodian or trustee to hold title to anything other than marketable securities and cash in an IRA, which makes it difficult to find a custodian for a self-directed IRA investing in real estate.

As you can see, there is more than just a yes or no question to answer when deciding whether or not to hold real estate in an IRA.  More times, than not, the costs and headaches outweigh the sometimes smaller than expected paybacks from holding real estate in an IRA.  While it may be possible to successfully hold real estate in your IRA, any lapse in following the IRS’ guidelines could result in a very significant tax bill and quite possibly, the complete disqualification of your IRA.

Learn more about when and how to hold real estate in an IRA. If you have any questions on if you should hold real estate in your IRA, contact an Anders advisor.