By: Randall A. Denha, J.D., LL.M.*
An IRA is a powerful financial planning tool that allows you to save for retirement, or provide benefits for your heirs, on a tax-advantaged basis. Most people invest their IRA funds in stocks, bonds and mutual funds. But others opt for nontraditional investments, such as real estate, in the hope of boosting their returns. While the idea of holding real estate in your individual retirement account sounds good and can offer higher returns than stocks or bonds, the process has a few pitfalls and traps. Annual contribution limits still apply, so if you don’t have enough in your IRA, you can’t just put in extra to cover the purchase.
If you choose to hold real estate in your IRA, be aware that there are several tax traps for the unwary, chief among them the prohibited transaction rules. Those rules disallow certain dealings between you (or your beneficiaries) and your IRA. Violation of these rules results in the full value of the IRA becoming taxable.
For example, you and your beneficiaries can’t sell or lease property to your IRA, buy or lease property from your IRA, use IRA property as a personal residence or office, lend to or borrow from your IRA, guarantee a loan to your IRA, pledge IRA assets as security for a loan or provide goods or services to your IRA. This last prohibition means you can’t provide property management, renovation or construction services, either by yourself or through a family member or a company you control.
Violations of the prohibited transaction rules result in termination of the IRA. That means you’ll be liable for taxes and penalties on the entire account balance, regardless of the transaction’s size.
Other considerations to keep in mind:
- In a traditional IRA, any capital gains eventually will be taxed as ordinary income. For regular investment property, you pay capital gains tax rates when you sell at a profit and can write off at least a portion of your loss against other income. Not so with assets held in an IRA. When you sell the property and take an IRA distribution, you’ll pay tax on any asset appreciation at income tax rates, not cap gains rates.
- If real estate is financed by a mortgage, some income may be subject to unrelated business income tax (UBIT).
- You cannot write off IRA losses.=
- Not all IRA custodians permit real estate investments, so you may have to open a self-directed IRA.
- If you have a traditional IRA, it must have sufficient cash or other liquid assets to fund required minimum distributions starting at age 70½. Put another way, unless other assets exist then you will have to sell the real estate property unless you have enough liquid IRA assets to withdraw.
*RANDALL A. DENHA, J.D,, LL.M., principal and founder of the law firm of Denha & Associates, PLLC with offices in Birmingham, MI and West Bloomfield, MI. Mr. Denha continues to be recognized as a “Super Lawyer” by Michigan Super Lawyers in the areas of Trusts and Estates Law; a “Top Lawyer” by D Business Magazine in the areas of Estate Planning and Tax Law; a Five Star Wealth Planning Professional and a New York Robertes Top Attorney in Michigan. Mr. Denha can be reached at 248-265-4100 or by email at email@example.com