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.
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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.