For clients who are experienced real estate investors with substantial retirement plan balances, making real estate investments through a self-directed IRA could make sense.
It’s a more complex than investing in traditional securities, of course. But it is manageable and gives clients potential diversification benefits, as well as the profit and income opportunities that real estate can provide.
Kelly Rodriques, CEO and president of PENSCO Trust Company in San Francisco is one expert who’s experienced at spelling out the steps to get real estate into an IRA.
First, Rodriques says, a client has to open a self-directed IRA with a qualified custodian that works with real estate investments, such as PENSCO.
After establishing the account, the client transfers funds from an existing retirement account to the new custodian through an automated authorization process. (PENSCO, for instance, provides advisors and clients with guidance and a checklist of documents detailing steps to be taken to preserve the IRAs’ status with both the Department of Labor and the IRS.)
This type of IRA is different from the usual plan, says Rodrigues, because it includes special instructions allowing the custodian to make the investment on the account owner’s behalf.
In addition, if the client is borrowing funds from a lender, the custodian must work with the lender to get the financing in place, since the custodian holds the assets.
Clients must follow the rules on permitted transactions within their account or they could encounter some very nasty taxes and penalties, experts say.
Here’s the high-level guidance on prohibited transactions from IRS Publication 590, Individual Retirement Arrangements (IRAs): “Generally, a prohibited transaction is any improper use of your traditional IRA account or annuity by you, your beneficiary, or any disqualified person. Disqualified persons include your fiduciary and members of your family (spouse, ancestor, lineal descendant, and any spouse of a lineal descendant).
“The following are some examples of prohibited transactions with a traditional IRA: borrowing money from it; selling property to it; using it as security for a loan; buying property for personal use (present or future) with IRA funds,” the IRS explained.
These rules are fairly clear, but it’s the nuances that can trip up investors, says Rodriques.
For instance, most investors will understand that they can’t sell a property they already own to their IRA —that’s the most obvious form of self-dealing.
“But, here’s something that’s a little more nuanced,” he pointed out. “I’m going to buy a property from my dad and put that in my IRA versus a property from my brother. You actually can buy a property from your brother and put that in your IRA. You can’t buy a property from your dad and put that in your IRA.
“Most people don’t know that or they wouldn’t know the distinction between whom you can purchase the property from and still have it qualify as a retirement investment,” the expert shared.
Managing the Property
After the property is in the IRA, the custodian handles mortgage and tax payments, payments for property maintenance and so on.
That increased workload necessitates higher fees than the usual securities IRA; Rodriques estimates that PENSCO’s base yearly fee for a property IRA is in the $300 to $500 range.
The arrangement appears to be attractive to financial advisors and their clients; he reports that participation from advisors and their clients has been growing, and real estate “does make up a very significant part of our business.”
Holding direct real estate investments in IRAs takes more effort, and clients incur higher costs than they would by owning IRAs with just traditional financial products as assets.
Plus, there’s no guarantee that the investment won’t lose value—the most recent price cycle highlights real estate’s price volatility.
But for clients who know what they’re buying and have the ability to ride out the cycles, real estate may fit nicely within their portfolios.