I’ve had a number of property owners call and ask if I think it’s a good idea to buy real estate in a self-directed IRA. Housing prices are down and interest rates are low – it seems many landlords are asking themselves, Why not…?
Before you make that purchase in your IRA, please carefully consider all the potential disadvantages that can be involved.
- No Depreciation – One main advantage to owning rental real estate is the ability to take a deduction for depreciation of an asset that is in essence going up or staying about the same in value.
- No basis step-up – If you pass away with real estate in an IRA, your beneficiaries would not get a step-up in basis. Outside the IRA, if you purchased the property for $100K, and when you died it was worth $250K, the gain would not be taxable. If it were inside a traditional IRA, the entire gain would be taxable.
- Valuations – Once you reach age 70.5, you are required to take required minimum distributions from your IRA. To determine the RMDs, an appraisal would need to be done every year as of December 31. The costs of the appraisal every year would need to be factored in. Liquidity is also an issue. If you don’t have enough cash to distribute the RMD’s – the property would have to be sold to meet those requirements.
- Expenses to fix up the Property – If you run into an issue where it’s going to take a large sum of money to fix a problem with the property and there is limited cash available within the IRA, you are limited to the IRA contribution limits on a per year, per individual basis. If you have to replace a roof that costs $10K, and have no cash available within the IRA to pay for that repair, you are limited to $5,000 per year without incurring an excise tax and penalty for excess contributions (or worse, your IRA may be disqualified).
- Unrelated Business Taxable Income (UBTI) – If you purchase real estate subject to a mortgage, you many incur UBTI, which would require you to file a separate tax return and pay tax on the income. These tax rates are graduated much higher than if you would have paid it individually.
- Higher Tax Rates – If you sell real estate outside your IRA, you are subject to depreciation recapture and capital gains tax rates. If you sell real estate within your IRA, you are subject to ordinary income tax rates. Capital gains/depreciation recapture rates are generally more favorable than the ordinary income tax rates.
- Personal Use Limitations – Within the IRA, you cannot use your property at any time for personal use, even if it’s a timeshare. You also cannot rent it to any lineal descendants.
- Higher IRA Custodial Fees – You will need to find a custodian that allows real estate in IRAs, and you will generally pay higher fees to have this privilege.
- Diversification Limitations – If you currently have real estate outside your IRA and then purchase real estate within your IRA, you are putting yourself at the mercy of the real estate market. Without the ability to diversify your assets, there is the potential for higher risk.
- Watch out for prohibited transactions between the owner and the IRA – If an IRA owner or beneficiary commits a prohibited transaction, the account ceases to be an IRA, and there is a deemed distribution for the Fair Market Value of all the assets. The deemed distribution would then be taxable at ordinary income tax rates and possibly subject to a 10% penalty.
- Cannot Pledge the Equity in the IRA rental property to buy another property outside the IRA – If an IRA is used as collateral for a loan, it then becomes a deemed distribution. If you have equity in a real estate holding inside the IRA, that equity cannot be used as a down payment for another property without making the entire IRA taxable.
Although it’s possible to hold real estate in your IRA, you need to make sure you tread carefully. As noted above one fluke or misstep can disqualify your IRA, causing a huge tax bill — and maybe a headache!
To meet the recently established requirements of the Internal Revenue Service as described in their circular 230, we hereby advise you that any tax advice contained in this communication was not intended or written to be used, and it cannot be used, for the purpose of avoiding penalties that may be imposed on the taxpayer by Internal Revenue Code.
Kam Wiese, CPA
Kluge and Wiese, LLP
620 N. Hwy 6, PO Box 500
Gretna, NE 68028-0500
All rights reserved.