For those with a penchant for real estate investing, IRAs are a potent vehicle. Outside of tax-advantaged accounts, rental income is taxed every year, and passive activity rules restrict your ability to claim losses from real estate. When you use a self-directed IRA to invest in real estate, you can accumulate all of that rental income tax-deferred, or tax-free if you hold the asset in a Roth IRA. If you have the patience, liquidity, and know-how to be a successful real estate investor, it can make perfect sense to leverage these skills with a self-directed IRA.
In order to enjoy the tax-advantages that accompany IRA accounts, the IRS has certain parameters in place regarding retirement accounts. If IRA real estate investors don’t understand and comply with these rules and regulations, you risk exposing yourself to unintended penalties and taxes.
Paying attention to cash flow is critical with real estate IRA investing. The law limits the amount of new money you can contribute to an IRA each year to $6,000 (or $7,000 if you are over age 50.) As any veteran property owner knows, property repairs and renovations can easily exceed this amount. This means you can’t intervene in your IRA-owned property with cash infusion from outside your retirement account(s), regardless of whether or not your property needs repairs.
For any expenses over the maximum annual contribution, you will need to pay by using liquidity that you have in the IRA itself, by rolling the money over from another eligible retirement account, or by having your IRA borrow the money. For this reason, it’s generally best to have some liquid reserves – cash, cash equivalents, reasonably stable securities, or a line of credit that your IRA can tap into for this purpose. Your checking account won’t do you much good when you have to pay for a $30,000 roof.
Outside of an IRA, the tax code provides a natural means for investment property owners to set aside some reserves. This is part of the logic of depreciation deductions – you’re supposed to set aside the savings to pay for expected repairs, maintenance, upkeep and eventual replacement. But you don’t get a depreciation deduction in an IRA. You need to set aside reserves from operating income within your IRA or be prepared to transfer assets from elsewhere.
Remember, you can’t lend money to your IRA personally. If your IRA needs to raise cash in a hurry, you can’t be the person to provide it, beyond allowable contributions and rollovers. The same applies to your descendants, your parents and grandparents, and any of their spouses. Ditto for any business entities they control. (The law does not specifically rule out your brothers and sisters, though).
The same people who can’t lend to your IRA also can’t borrow from it, for the same reason (though you can use your self-directed IRA to lend money at interest to whomever else you like.)
Likewise, you can’t do business directly with your IRA, nor can any other disqualified individuals, nor can their spouses or any business entities they control. Some people try to open a property management company, or construction company, and have their IRAs compensate their companies directly for services rendered. This is prohibited by the IRS.
If you hold a real estate investment outside a retirement account, and sell it at a profit, you pay tax at capital gain rates. If you held it for more than a year, your capital gain tax will be less than your income tax. However, if you hold the property in a tax-deferred retirement account, you will need to eventually pay income taxes on any gains, rather than the lower long-term capital gains rate. To avoid this, consider using a Roth IRA to hold real estate or capital assets in an IRA. You don’t get a current year tax deduction, and you can’t take depreciation deductions in either case. But any gains are tax free. Additionally, you sidestep the eventual problem of taking required minimum distributions when you get older, which can be a challenge if your retirement portfolio is in illiquid holdings such as real estate.
Ordinarily, rental properties allow you to spend a couple of weeks per year in them without jeopardizing their status as investment properties. This is not true for IRA-owned real estate. You can’t live in the property, even if you’re paying rent. You can’t even stay overnight in the property. What’s more, you can’t let your children, grandchildren, parents, grandparents, or their spouses stay overnight either. If you do, the IRS could consider it a distribution, and impose a tax equal to 100 percent of the amount involved.
Many people are confused by IRS prohibitions on lending to or borrowing from your IRA personally, or pledging your IRA as collateral for a loan, and think that you cannot borrow money for your IRA at all. In fact, your IRA can borrow money. But understand that it’s your IRA that’s borrowing the money – not you. This distinction is crucial. Your IRA can only borrow money from non-disqualified individuals and entities on a non-recourse basis. This means that if the loan should default, the lender can only come after the IRA to collect. Only assets held within the IRA can serve as collateral for the loan. You cannot pledge anything outside the IRA as collateral, nor sign a personal guarantee of any kind.
Taxes? In an IRA? Alas, yes. While your IRA can defer income tax and is generally exempt from capital gains tax, you still have to pay property taxes if you own real estate in your IRA. Additionally, if your IRA employs leverage – as is common for real estate investing – your IRA may be subject to unrelated business income tax (UBIT). New Direction Trust Company does not give tax advice, so you should retain the services of a qualified tax advisor, such as a CPA, tax attorney or enrolled agent, for advice specific to your situation.