The tax benefits of owning real estate in an IRA plan certainly seem appealing at first glance.
Under a self-directed IRA, you can control your investments, and the tax benefits of owning real estate in an IRA plan certainly seem appealing at first glance. In a Roth IRA, contributions are made with after-tax dollars, and the earnings on your investments grow tax-free, and can later be withdrawn tax-free. Under a traditional IRA, contributions are tax deductible up to $5,600 each year, and the investments there-under grow tax-free and are not taxed until they are withdrawn years down the road.
Anyone considering using these tax advantaged vehicles for an investment in real estate should proceed with caution. It can be extremely dangerous to hold private real estate or a direct small investment company or LLC under an IRA because of the IRS’s strict rules on self-dealing and conflicts of interest which are referred to as Prohibited Transactions.
A “Prohibited Transaction” is defined under Section 4975 of the Internal Revenue Code. A few of those Prohibited Transactions include any direct or indirect: 1) sale, lease or exchange of property between a plan and a disqualified person; 2) a loan or any extension of credit between a plan and a disqualified person; 3) furnishing of goods, services or facilities between a plan and a disqualified person; and 4) transfer or use of the income or assets of a plan to a disqualified person (including using the assets indirectly for the benefit of that person). A violation of one of these rules, even if the benefit flowing to the owner from the IRA is $1.00, can result in large taxes and penalties, including having to pay taxes on the entire balance of your IRA as if you cashed in the entire account. These Prohibited Transactions apply to uses of your IRA by you, your family, your beneficiaries or any disqualified person.
For example, using assets from the IRA to pay off a personal credit card bill is not allowed. Another example would be if the IRA owns rental property directly, or via an LLC, and you go into the house to put a $6.00 paint touch-up on a wall, then you have committed a prohibited transaction. The same is true if a person related to you, or a business you own, paints the house or provides some other service to the property. If you sleep inside the house for just one night, there is an argument that you have derived an indirect benefit and the IRA can be disqualified from its tax exempt status.
This can also apply if your IRA owns, let’s say, 20% of an LLC that invests in real estate with some friends or colleagues of yours. If you contribute time or effort to the success of the LLC, inadvertently pay any of the LLC expenses directly or receive any personal benefit, such as attending a barbecue paid for by the LLC that your IRA owns 20% of, then your IRA could be disqualified.
As a result of this, it is expected that IRAs handled by the few custodians willing to make these types of investments will be subject to a high rate of audit.
Investors who want to have real estate under their IRAs will be much safer purchasing a publicly traded security, such as a REIT (“Real Estate Investment Trust” ) that invests in real estate through a traditional and conservative IRA custodian.
Another potential tax trap that could occur with this type of investment is Unrelated Business Taxable Income (UBTI), which is defined in IRC sections 511-514. If an IRA owns an asset, like real estate, that produces unrelated business taxable income, it will have to pay taxes on that income. One of the most common forms of unrelated business taxable income occurs when income is earned through the use of debt, which is referred to as “debt financed income.” For example, if the IRA operates a business, or receives income from a leveraged investment such as rental income from a mortgaged property or stock that is purchased on margin, it will be considered as Unrelated Business Taxable Income subject to tax as well as the filing of additional tax forms.
In addition, with individual high earner taxpayers facing a 37% tax rate and a 3.8% Net Investment Income Tax on REIT distribution income, many taxpayers will want to place REITs under their IRAs or pension accounts, and may purchase municipal bonds, depreciation and interest sheltered individual real estate investments and other items under their personal names for a more tax efficient allocation.
If you do choose to invest in real estate under an IRA, even after reading the precautions in this article, please consult with a tax adviser who is fluent in the Prohibited Transaction rules so that the investment can be structured to avoid the many traps for the unwary applicable when non-traditional investments are held under an IRA.