Summer vacations are the perfect time to find a dream home in an ideal location. Investors are often in the market for clever solutions for affordability, so it’s important for them to be aware of all of the available investment tools. One such tool is the self-directed IRA. Did you know that your IRA/401k funds can be used to buy real estate? Let’s look at some of the options available for purchasing a second home with IRA funds.
This scenario is the simplest. Existing IRA or 401k funds are used to fund the investment account. The IRA directly owns the property and receives special tax treatment by the IRS.
PROS: If you love this home and this area, chances are others will too. Vacation homes in desirable locations can be valuable investments. The property may be rented out to vacationers and earned income grows tax-deferred or tax free in the IRA. Many investors also enjoy holding hard assets like real estate in addition to or instead of paper assets as part of their portfolio.
CONS: You cannot personally use any real estate owned by your IRA account. This second home would be purely for investment purposes. The IRA must pay all expenses associated with the vacation home.
IMPORTANT CONSIDERATIONS: Compare the return on investment for the vacation home, whether from rental or resale to the return on investments currently held by your retirement account. If cashflow and/or returns on the vacation home are higher, it is probably worth looking at the investment as a potential option for your IRA/401k plan.
Up to age 59 ½ this option would work identically to Option 1 above. At age 59 ½ you can elect to take a percentage (up to 100%) of ownership in the IRA-owned property in lieu of cash distributions from the IRA. Once you have distributed 100% ownership, you are permitted to use the property as a vacation or primary home.
PROS: Purchasing the property now protects your ability to own the property at retirement. As real estate in popular resort areas continues to rapidly rise, you will have locked in your price at today’s cost.
CONS: This strategy requires patience. You cannot personally use the property until you have distributed 100% ownership after age 59 ½.
IMPORTANT CONSIDERATIONS: Taking the property distributions can take time. Talk with your advisors and make sure that you are willing to wait the necessary time.
This scenario is the most complex and will require consulting with a team of professionals to execute properly. Essentially, the IRA invests in an annuity or other investment with guaranteed payments or stable cashflow. As money flows into the IRA account from the annuity or other investment, payments are received as a distribution (without penalty) by the IRA holder. These distributions are used to pay the mortgage on the second home, which is held directly by the individual, NOT by the IRA account.
PROS: You can begin using the property immediately as it is owned directly by you. This strategy provides investment capital for investors with IRA balances that are larger than personal cash savings.
CONS: Investor must be 59 ½ or older in order to take advantage of a 72t exemption. Since the property is owned directly by you and not the IRA, you lose all of the tax advantages of IRA-owned properties. As a result, taxes apply to the sale of the property as well as the rental income. Income tax is paid on the distributions used to pay the property mortgage.
IMPORTANT CONSIDERATIONS: You must already have enough wealth to create the annuity providing guaranteed payouts substantial enough to pay the property mortgage.