There are many advantages to tax-deferred investments in IRAs. These accounts have allowed many investors to build sizable nest eggs and ensure a comfortable, enjoyable retirement.
Unfortunately, there are potential tax traps when investing in real estate within your IRA accounts. Some of the traps can be catastrophic for the IRA owner and should be avoided at all costs.
1) Avoid prohibited transactions. When an IRS auditor determines under audit that a taxpayer engaged in a prohibited transaction, the transaction is treated as though the IRA account investments are fully distributed and taxable to the IRA owner. Even worse, the taxpayer pays ordinary income tax rates as high as 37% plus penalties, plus interest. If the IRA owner is under 59 1/2 years old, there is an early distribution penalty of 10% tax, underpayment penalties plus accrued interest charged on top of the tax and penalties owed to the service. If the auditor feels that the prohibited transaction was intentional, they can impose even more severe penalties based on negligence standards.
What are the “badges”, audit indicators, of prohibited transactions involving real property in an IRA?
i) Related parties such as your relatives or business partners are not allowed to occupy or work on the real property. Remember, the property owner is the IRA not the IRA owner personally. If the property is a rental, a property manager must be hired to find tenants. All expenses related to the property, including annual repairs and maintenance, must be paid from the IRA. If you pay those expenses, you have committed a prohibited transaction.
ii) Borrowing money from the IRA is a prohibited transaction. This eliminates the opportunity to leverage the property, a critical advantage for real estate investment compared to other investments. All investments in IRA assets are required to be in cash payments.
iii) Taxpayers cannot use real estate assets in their IRAs as security for a loan. Again, this a major disadvantage for real estate investors who are able to leverage their assets to grow their portfolio of real estate investments.
iv) Taxpayers are also not allowed to use funds in their IRAs to buy real estate for their personal use.
2) In an IRA account, real estate investors cannot take common real property deductions such as mortgage interest, taxes, repairs, association dues or depreciation on the property.
3) When you cash out of an IRA investment in real estate, the distributions are taxed at ordinary rates not the lower capital gains tax rates. Distributions from IRAs in effect convert lower taxed capital assets to higher taxed assets, subjecting the owner to ordinary income tax rates as high as 37% compared to the highest capital gains tax rate of 20%.
There are good alternatives other than direct property investment which allow IRA owners to reap the benefits of real estate investments while enjoying traditional real estate tax deductions:
a) Real Estate Investment Trusts (“REITS”) are one option. REITs are diversified, professionally managed real estate trusts similar to mutual funds, and the entities are able to deduct all regular and recurring expenses such as depreciation; they have the potential to appreciate in value; and they are readily marketable, if they are publicly traded. Many REITs also have the advantage of global diversification in real estate.
b) Limited partnerships which invest in real estate can be another good option for IRA owners who are seeking diversified real estate investments. If the partnership is publicly traded (PLP), they are easily purchased and sold too. With both REITs and PLPs investors need to be aware of any fees commonly known in the mutual fund world as “load fees” and annual management expenses. Both of those can reduce investors’ returns. Before proceeding, each investor must make sure such investments are in their best interests, help further their financial goals, and fit within their risk tolerance.
We welcome your comments on the topic, and are pleased to offer a complimentary meeting to discuss your questions on these important tax and wealth management issues.
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