Nathan Foran used his self-directed IRA to buy a dilapidated foreclosed house in Richmond for $25,000 cash. Another $25,000 to $35,000 from the retirement account will go toward fixing up the property. He then hopes to rent it out for about $1,000 a month, money that will go straight into his retirement account.
Mr. Foran, 40, a San Anselmo real estate broker and investor, sees a lot of advantages in investing in real estate through his individual retirement account.
"The net rental income goes into the IRA, so it's generating money tax deferred," he said. "Once I sell, the money also goes directly into the IRA without capital gains tax. If I hold onto it for five to seven years, it probably will be worth in the low $200,000s, so I'll get a sizable gain. If I find another property I think will appreciate faster, I can sell this and use the funds to invest in that one. The IRA is a good long-term investment tool."
With many properties at bargain-basement prices, more people have been turning to their self-directed IRAs as a ready source of capital to make real estate investments. Companies that manage self-directed IRAs say real estate investments by their clients are up as much as 30 percent over the past year.
But experts caution there are a range of potential issues and gotchas – including ones that could even disqualify the entire IRA.
Self-directed IRAs account for just 2 percent of the $4.2 trillion IRA market, but are among its fastest- growing segments. They allow access to a variety of investment vehicles beyond just stocks and bonds. The IRS closely regulates them, and any real estate investments must be handled by IRA custodian firms that hold the property inside the IRA.
Can't live in property
IRA owners can invest in any kind of real estate – raw land, commercial properties or residential rental properties. They cannot invest in a property they already own or plan to live in, however.
The retirement funds "represent a large amount of untapped capital for investors that they can more actively manage," said Brad Hemstreet, vice president of sales and marketing for Equity Trust Co., a Cleveland company with $8 billion of IRA funds under management.
After the recent stock market downturn, "people are pulling out of Wall Street and want investments they understand and are comfortable with," he said. "Many people look at owning a property as a far better investment than owning a stock or bond."
Mary Kay Foss, a CPA and director of the Danville office for accounting firm Greenstein, Rogoff, Olsen and Co., said using IRAs to buy real estate can negate many tax advantages.
"Real estate is already one of the best investments you can have, tax-wise, because you can deduct all of your expenses, and when you sell it, you pay long-term capital gains (at 15 percent, much lower than income tax)," she said. "But if you have it in an IRA, none of the expenses are deductible. When it's sold, any profit is taxed when you take it out (of the IRA) as ordinary income."
Investing in real estate with a Roth IRA has fewer drawbacks, she said, because distributions are tax-free once the account has been in place for at least five years, although "you still have the downside that you can't deduct any expenses."
Must follow IRS rules
People who invest in real estate through an IRA have to make sure they adhere to IRS rules or they risk disqualifying the account, which carries heavy tax penalties. Neither they nor their relatives can live in the property. They cannot pay any expenses directly; everything from repairs to property taxes must be funded from the IRA. That means they must make sure their IRA has enough liquidity to handle expenses. If they have to add money, they pay a penalty.
"At this price point, I'm able to do the entire transaction with my IRA," Foran said about his $25,000 property. "I wanted to be very safe and make sure I have plenty of buffer in there so I won't have to do a capital contribution to keep that property afloat."
Companies that manage self-directed IRAs said they fully disclose all rules and recommend that investors educate themselves and consult their own accountants.
"Generally people in the real estate IRA business are very savvy about the market and investment properties," said Hugh Bromma, CEO of Oakland's Entrust Group, which has $4 billion in IRA funds under management. "They're picking up selected properties in areas that will be conducive to long-term appreciation."
About 30 percent of Entrust's clients invest in real estate, he said. Foran is among them. Entrust charges $250 a year to manage a single property, plus fees for purchasing the property.
Most IRA real estate investors buy properties with all cash, the simplest approach. If they don't have enough funds to do that, they can partner with other IRA account owners, or even partner with themselves, for instance paying half from their IRA and half from their personal savings.
30% down required
A handful of banks offer mortgages to IRA investors, but they must put down at least 30 percent, and they pay a higher interest rate because the loans must be nonrecourse, meaning the banks cannot go after other assets.
Once IRA account holders reach age 70 1/2, they must start taking minimum required distributions from their account. What if they have a house held in the account and can't sell it? "You can take a portion of it and transfer it to yourself," said Kathy Holcomb, business development officer at Pensco Trust Corp., a San Francisco IRA management company.
Suzanne Gregg, an agent with Paragon Real Estate Group in San Francisco, has bought and flipped a couple of properties through her IRA and said she tripled her money.
"It's not like you just buy a stock online and forget about it; it's a little more hands on," she said. "It's a tangible asset you can see and manage."
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