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May, 2005 Tax Tip

Think About Buying Real Estate in Your IRA


I recently attended a presentation on self-directed investment retirement planning.  Perhaps if I thought about it I wouldn’t have been surprised that the speaker said that just over 1% of all investments in retirement plans were in mutual funds.  Sure, through good years and bad years these investments will certainly grow over time, but at what rate – 8%, 12%, 15%?  Most people investing for their retirement would probably be quite pleased with that.  However, to attain those rates, you would likely be taking more of a risk by investing in growth stocks.


Instead, what if you were to consider taking advantage of the real estate market and invest at least a portion of your IRA in appreciating real estate that can later be sold for profits that could put the rates mentioned above to shame?  An increasing number of IRA’s are switching their funds to real estate through self-directed accounts held by a custodian and managed by the IRA’s owner.  So long as the IRA isn’t engaged in an active business or doesn’t have debt financed income, it pays no taxes on profits generated.  Rental income is specifically excluded from the definition of active business income.


Why hasn’t this been done more often?  The answer is probably that either the IRA owners didn’t realize they could own real estate in their IRA or there is little financial incentive for financial institutions to recommend investments other than stocks or mutual funds.  Now that real estate values are leaving stock market gains in their dust, more investors are moving their funds accordingly.


So having said that, should everyone rush to put their retirement nest egg into the real estate basket?  Like most things in life, one size doesn’t fit all.  Because of the many regulations that govern IRA’s as well as other tax-sheltered accounts, doing real estate transactions in them can be complex and not to follow the rules can lead to severe penalties.  If an investor were to own real estate outside the IRA, he would be allowed to take all the deductions that go with owning real estate, including depreciation.  This, of course, is not true of an IRA.  Further, real estate owned by an IRA cannot be used as the primary residence, vacation home, or the place of business of the IRA owner.  These would be prohibited transactions.


Proponents feel the advantages outweigh the disadvantages.  They see enhanced growth from rental income and property sales as well as the wide latitude they have on what they can buy, ranging anywhere from raw land to hotels and shopping centers as reason enough. 


Roth IRA’s would be the favored way to hold real estate, especially appreciating property.  That is because distributions when made will not be subject to tax, unlike in a traditional IRA where all amounts withdrawn are taxed as ordinary income.




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