Do IRAs and Real Estate Make for a Prosperous Combination?

Individual Retirement Accounts (IRA) are often considered by real estate investors. The issue discussed here isn’t whether or not one can use an IRA in real estate - it’s how.

“It’s legal, but Mr. and Mrs. America won’t be able to follow the rules,” Boston lawyer Natalie Choate said at a recent Orlando conference.

She said real estate is a fine IRA choice if takes the form of a totally hands-off investment such as a real estate investment trust, real estate mutual fund or partnership managed by a general partner. It’s when investors want to be personally involved that they get into trouble, she said.

Choate and fellow IRA expert Ed Slott say these are some of things you need to know if you are thinking of investing your IRA directly in real estate:

You need a big chunk of money. You either have to pay cash or find a lender willing to loan money to your IRA without your personal guarantee, which will mean a large down payment.

You need enough extra money in your IRA to pay for home repairs, taxes and other costs if a tenant moves out or your cash flow projections don’t materialize. You can’t contribute more than $5,000 a year ($4,000 if you’re younger than 50) to your IRA - and lending money to your own IRA is illegal.

You need an IRA custodian who will hold and manage the real estate for a reasonable fee. Choate says IRA custodians who offer to let you do the managing are in legally murky territory.

If you are thinking about fixing up the property yourself, be aware that your sweat equity could be considered an excess IRA contribution.

Although IRA earnings are otherwise tax deferred, the income your property earns may be classified as “unrelated business taxable income” - and if it’s more than $1,000, your IRA will have to pay taxes on it.

Your property will have to be appraised annually to determine the year-end value of your account. Once required distributions begin, if you don’t have other IRA assets, your IRA wil l have to issue you a deed for a fractional interest in the property each year.

Real estate offers tax advantages that don’t do you any good when it’s held in an IRA. Among them: Profits that would be taxed as capital gains outside an IRA become ordinary income taxed at higher rates when distributed from an IRA.

You have to be very careful not to run afoul of rules against self dealing, which means transactions cannot provide even an indirect benefit to you or your family.

The big risk: If you break the rules, the IRS can make your entire IRA taxable. So be careful with your Florida home loan and how you go about affording it.