Although not a new concept as an investment vehicle, many seem to find the idea of purchasing a property within a Real Estate IRA as something recent. We have been hearing about this approach for some time, and after I attended a recent RAM session that featured a speaker discussing the tax aspects of home and rental ownership, my wife and I decided to investigate the possibility of purchasing rental property within a Real Estate IRA.
First of all, I am not licensed to give investment or tax advice. I am merely sharing the process that we are using ourselves for our next purchase here on Maui. It is very important that you consult with a professional such as an accountant and/or an attorney prior to moving forward with this approach (and I will continue to repeat this throughout this article!). I am only sharing the process that we are experiencing.
The Custodian or Trustee
With Real Estate IRA’s, a custodian or trustee is required. This would be a bank, or other entity approved by the Internal Revenue Service, not an individual. We chose a custodian, and moved the funds from a Traditional IRA, 401K, 403B, etc. to the Self Directed IRA with the custodian. The new IRA has a name and an account number. Once we select the property that we wish to have the IRA purchase, the purchase contract, title, etc. are all in the name of the IRA.
There Are Potential Advantages When Considering Purchasing Real Estate in an IRA
A wonderful advantage to having an IRA is it allows the potential for tax deferred growth within the IRA account. As an example, let’s say that an IRA exists, and the IRA purchases 100 shares of stock for $90 per share, for a total investment of $9,000. After a period of time, the value of the stock goes up to $150 per share, for a total value of $15,000. In the IRA, the $6,000 gain is tax deferred, until disbursements are received.
When the IRA purchases real estate, there are potential advantages. Let’s say that the IRA purchases a property for $320,000 cash and it is rented out long-term to a tenant. All rent proceeds are made out to and paid directly to the IRA. The IRA pays for all expenses, i.e., HOA fees, real property taxes, repairs, etc. In the event that the rents provide a positive cash flow, those dollars build up within the IRA tax deferred.
Gross Rental Income: $2,150 per month
Taxes (at $6.00/$1,000): $160 per month
HOA: $318 per month
Management Fee (10%): $215 per month
GET (4%): $86
Approximate Total Monthly Expenses: $779 per month
Approximate Net Monthly Income: $1,371
Approximate Yearly Net Income: $16,452
Approximate Yearly Return from Rent: 5.14%
Let’s say the IRA owns the property for 4 years, and enjoys a net build up within the IRA of $65,808 ($16,452 x 4 years). Now the IRA sells the property. Assume that after closing costs and commissions paid for by the IRA, there is a net profit of $100,000. The $100,000 and $65,808 would represent a total gain of $165,808, all of which would be tax deferred. That would represent a return of approximately 51.82% over a 4 year period, or approximately 12.95% per year, with no capital gains tax, since the gain within the IRA is tax deferred.
Consult with a professional such as an accountant and/or an attorney prior to moving forward with this approach.
There Are Potential Disadvantages When Considering Purchasing Real Estate in an IRA
Disqualified persons are people who cannot utilize the real estate purchased within an IRA.
Disqualified persons can include among others:
- IRA holder and Spouse
- Son and Daughter-in-law
- Daughter and Son-in-law
- Grandchildren and grandchildren’s spouses
Prohibited transactions for disqualified persons can include:
- Buying a property or asset from the IRA
- Selling a property or asset that you already own to the IRA
- Living in the property themselves
- Using the property as a vacation home or for any other reason
- Renting the property for themselves…even if they pay fair market value
- Paying expenses for the property with personal funds
- Being paid by the IRA
- If a disqualified person is a real estate professional, accepting a commission on the purchase or sale of the property
- Putting personal property or sweat equity into the property
- If the IRA directly or indirectly benefits OR is benefited by a disqualified person, that constitutes a Prohibited Transaction
If you are considering purchasing Real Estate within the construct of an IRA, it is important to work with professionals who have experience in this arena. Please feel free to call or email me with questions. I can also discuss other important issues with you, such as:
- Making an offer
- How and where to sign documents (since the IRA is the Buyer/Owner/Seller)
- Correctly title your IRA investment
- How to make an earnest money deposit
- The closing procedure
- Property Income
- Managing property expenses
- Property managers
- Selling an IRA-owned property
- Possible repercussions when the rules are broken
Again: Consult with a professional such as an accountant and/or an attorney prior to moving forward with this approach.
Rick Wyffels, Realtor-Broker, MS, RSPS