Unconventional IRA investments, usually in real estate, are a hot topic now in the media. Many IRA owners are excited by the booming real estate market and are still a bit leery of the stock market, so they naturally want to put their IRA assets to work where the excitement is.
The good news is that IRA investments in real estate are perfectly legal. The bad news is that there are several hurdles to navigate for a successful IRA investment in real estate.
One drawback to IRA investments in real estate is unavoidable. If an IRA finances real estate with a mortgage, as is typical with real estate investments outside an IRA, some of the IRA’s income on the investment will be “unrelated debt-financed income” and will be independently taxable to the IRA. There is no way to avoid this extra tax except to limit an IRA to unleveraged real estate investments.
A second hurdle to IRA real estate investments is ownership and management. Most typical IRA custodians (banks, brokerages, insurance companies) are unwilling to hold unconventional investments in an IRA. Once an IRA owner does find one of the more “flexible” IRA custodians, the question is who will manage an apartment building owned by the IRA.
The IRA owner himself cannot collect rents and pay bills. It must be done either by the IRA custodian or by an unrelated professional manager. Otherwise, any rent collected by the IRA owner would be a distribution from the IRA, and any bill paid by the IRA owner would be a (possibly illegal excess) contribution to his IRA.
The prohibited transaction (PT) rules also pose complications for IRA real estate investments. Engaging in a PT can cause disqualification of an IRA (and an instant deemed distribution of the IRA’s entire assets). The good news is that avoiding a PT is rather easy. The bad news is that many people misunderstand the rules and engage in PTs unwittingly.
The PT rules prohibit any act by a fiduciary (including the IRA owner) “whereby he deals with the income or assets of a plan in his own interests or for his own account.”
As interpreted by the IRS, the Department of Labor and the courts, the prohibition goes far beyond dealing with “disqualified persons” as defined in the PT rules. Under their interpretation, a transaction cannot in any way directly or indirectly benefit any person in which the IRA owner “has an interest.” This means an owner cannot have his IRA loan money to a business in which he or any relative has an interest, even a minority interest.
One DOL advisory opinion even found that a favorable real estate transaction with a private school was prohibited where the IRA owner’s sister worked there as an employee.
If an IRA owner is not discouraged by these hurdles, investing in real estate is perfectly legal and undoubtedly can be profitable. If the IRA owner hires an unrelated professional management company to handle the real estate owned by the IRA and avoids any business deals where he has a connection to the other side, he will go a long way toward charting a smooth course for his IRA.
John Fenton, J.D., M.S.B.A., is a staff writer for Tax Facts, a National Underwriter Company publication. He can be reached at email@example.com.
There are several hurdles to navigate for a successful IRA investment in real estate