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Can You Use Your IRA to Buy Real Estate?

IRA-calculator-penYou can hold real estate in your Individual Retirement Account (IRA). However, just because you can do something doesn't always mean you should. This article explains what you need to know before buying real estate for your IRA.

First, understand that you can't just use any old IRA if you want to include real estate in your portfolio. If you want to invest in real estate, you need a self-directed IRA to get started, and a custodian that allows them.

What is a self-directed IRA?

When you have a self-directed IRA, you can choose from a wide array of investments, including real estate, art, and even race horses. However, if your account is with a bank or brokerage, the most typical IRA account custodians, you're unlikely to have this option.

To make these investments, locate a custodian that allows self-directed accounts. Your account custodian is the financial institution that keeps your account records and sees that you comply with IRS requirements.

If you have a traditional IRA, you can convert it to a self-directed IRA, by finding a new custodian (if necessary) and transferring the account.

You can convert traditional IRAs, SEP IRAs, Roth IRAs, 401(k)s, 403(b)s, Coverdell Education Savings (ESA), Qualified Annuities, Profit Sharing Plans, Money Purchase Plans, Government Eligible Deferred Compensation Plans and Keoghs to self-directed accounts.

Opening a self-directed IRA

Self-directed IRAs are more complicated, so seek a custodian that offers a higher level of service to ensure you meet all aspects of the Internal Revenue Code when buying real estate for your IRA.

When you self-direct and control your own investments, you must report the value of your investment every year to your custodian.

Self-directed IRAs can come with more complicated fee structures. Compare custodians, and make sure that you understand fully what you are paying for and what you'll be getting for your money. These fees affect the return on your investments.

To protect your personal assets from litigation when you hold real estate for investment, you may be advised to establish a limited liability company (LLC) to hold your properties, and that increases your costs.

Your IRA real estate properties

Most investors buy income-generating rental property for their IRAs. Some choose to sell their primary home (excluding up to $500,000 in capital gains from their taxes) and convert one of their rentals to their primary home once they retire.

Note that your custodian is a neutral party. It can't advise you about what property to buy, so you'll have to do your own due diligence. A skilled real estate agent, attorney and perhaps an accountant or finance pro can be helpful here.

If you want more assistance, enlist a company that specializes in finding real estate for retirement investing. If you plan to buy and flip properties in your IRA, an IRA LLC (set up by an attorney) can facilitate the frequent buying and selling of properties, and even allow you to add and subtract investment partners.

Non-recourse IRA loan

If you need to finance your income property, the mortgage must be a non-recourse loan. That means the lender must not be able to go after you and your assets in the event of a default when the sale of the property doesn't cover the entire outstanding balance.

Many states require that mortgages on primary residences be non-recourse. However, that doesn't generally apply to mortgages on investment property. You can find such financing by asking mortgage lenders for non-recourse IRA loans. You should understand that the mortgage rates on these loans may be higher than current mortgage rates for traditional purchases.

In addition, you can't use any non-IRA funds to close on the mortgage, because it is illegal to co-mingle any of your non-IRA money with IRA account funds or assets. Finally, be cautious about adjustable rate mortgages. If your mortgage payment makes an unexpected jump, your account could end up short of funds and in trouble. A fixed-rate mortgage is a safer option when investing for your retirement.

Self-directed IRA real estate investment: pros and cons

Buying real estate with self-directed IRA funds is complicated, and managing it is expensive. There must be a compelling reason to jump through all those hoops. Here are the pros and cons of self-directed IRA real estate investment.

Pros of IRA real estate

The biggest reason you might have for buying real estate with self-directed IRA funds is the potential for tax savings. Putting your real estate into an IRA allows you to defer its income from taxation until you withdraw it. If you put your investments into a Roth IRA, your investment gains accumulate tax-free and you can also withdraw them tax-free.

You have the freedom to buy or sell properties, and you can move funds from one property to another. You can purchase the home you want to live in when you retire, use it as income property for tax-deferred income, and move into it later. This lets you secure your post-retirement residence now, at today's prices, and fix your mortgage at current rates.

Many people prefer to invest in something with which they are familiar, like local real estate, than subject themselves to the fluctuations of the financial markets. While stocks can fall to zero if the company goes under, chances are a house may remain "in business" for many decades after you buy it. And you can insure it to protect yourself from hazards.

Rental real estate delivers income even if its paper value drops, as long as it stays rented. You have two potential income streams in play: the rental income and property appreciation.

Cons of IRA real estate

You must follow many rules governing IRAs exactly, or you could find yourself paying stiff penalties. For example, you can use your self-directed IRA to buy the home you'll live in after you retire, but you can't live in it until you do.

You also cannot move property that you already own into your IRA. If you purchase an asset like a vacation home for your IRA, you can't use it for your personal benefit. This is called self-dealing, and could kill your IRA's tax status. In a worst-case scenario, the entire IRA becomes taxable. A 10 percent early withdrawal penalty also could apply. This is much harsher than the penalties applied to traditional IRAs, which generally are restricted to a 10 percent penalty on just the withdrawal.

Investment property in an IRA loses some of the tax breaks you might want now. For instance, you can't claim depreciation or deduct property-related losses from your ordinary income.

To take advantage of the IRA's tax benefits and avoid costly penalties, be sure that there is enough in your account to cover the expenses that come with owning rental property. Taxes, maintenance, management fees and other costs must come from funds that are in the IRA, including your annual contribution. Likewise, all income must stay in the IRA account.

Understand IRA real estate risks

Those with self-directed IRAs can earn more on their investments. But real estate, while relatively safe, is not completely fool-proof as an investment.

If investing in property ties up the majority of your IRA, you could find yourself dangerously under-diversified. To minimize risk, your IRA should be spread among several classes of investments -- for example, stocks, bonds, CDs and mutual funds. Real estate is more expensive than most of these other things, and if you tie up all or most of your money in property, you could earn less than you would in a diversified portfolio.

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