Millions of Americans have taken advantage of the ability to contribute money to an Individual Retirement Account (“IRA”) on a tax deductible and tax deferred basis and to delay the required distributions until their retirement years. While most Americans invest the assets of their IRAs in stocks and bonds, there are many other investments available to them through their IRAs, including investment in real estate.
An IRA is a trust or custodial account set up for the exclusive benefit of the taxpayer or his or her beneficiaries. The trustee or custodian of the IRA must be a bank, a federally insured credit union, a savings and loan association, trust company, or other entity approved by the IRS. The Internal Revenue Code prohibits the following as investments for IRAs: life insurance and collectibles (art, antiques, gems, coins, stamps, wine, etc.), commodities, and S corporation stock. Thus, individuals may direct the trustees to invest their IRAs in many different assets other than the traditional stocks and bonds. Among the assets the IRA owner may direct the trustee to invest in is real estate, including vacant land, commercial buildings, apartment buildings, condominiums, and the like. The advantage of ownership of real estate in an IRA is that both the income generated by the asset and any gains on the sale of the asset are deferred until required distributions begin. On the other hand, losses from operations, depreciation or other deductible items, will remain in the IRA and will not benefit the taxpayer individually.
Because contributions to an IRA must be in the form of cash, a taxpayer cannot contribute a real estate asset directly to the IRA – the taxpayer must contribute cash to the IRA and then direct the trustee to purchase the real estate. There are other restrictions as well. For example, an IRA cannot purchase real estate from the taxpayer, nor can the taxpayer use the real estate personally at any time or lease the property to a related person. Thus, the IRA could not lease space in an office building owned by the IRA to a business owned by the taxpayer, purchase a condominium to be used by the taxpayer’s child while the child is attending college, or own a vacation home that the IRA owner “rents” from his or her IRA.
Further, the IRA owner cannot manage the real estate – it must be managed by an independent third party. Also, one must keep in mind that no beneficiary of the IRA can be the manager or otherwise receive a benefit, such as a brokerage commission, in connection with a real estate owned by the IRA. Some of these issues can be overcome by forming a limited liability company to operate the business for the IRA, but the taxpayer must be aware of the issue of unrelated business taxable income, or UBIT. This issue can arise if one attempts to invest in real estate through a limited partnership or limited liability company. The IRS treats income from such entities as business income rather than investment income and imposes a tax on the profits. Considering that depreciation, mortgage interest expense, and operating expenses may reduce the taxable income, a taxpayer may decide the tax deferral benefit is enough to outweigh the small amount of UBIT that may result. UBIT can also be an issue if part of the acquisition cost of the real estate owned by the IRA is financed. If the property is financed, the IRS will claim the income from the financed part of the real estate is taxable.
There are fairly onerous penalties for failure to observe the rules. The IRS may treat a non-qualifying investment as an early withdrawal from the IRA, taxing it as ordinary income and imposing a 10% penalty.
If you desire to discuss the investment by your IRA in real estate or other specialized assets, please do not hesitate to contact us.