Did you know that it’s possible to buy real estate in an individual retirement account (aka your IRA)? Given that possibility, we’d like to walk through the rules and restrictions, as well as the pros and cons, of this option.

The main benefit of owning real estate in an IRA is the tax deferral. This means if you sell the property for a gain, there is no taxable event (as a reminder, IRA money is only taxed when withdrawn, or never taxed if it’s a Roth IRA). A second benefit is that rental income is deposited back into the IRA tax-free.

While these benefits sound appealing, the downside of owning real estate in an IRA is that there are lots of rules and regulations. Rule #1 is that you cannot use your IRA to purchase a primary residence or vacation home. In fact, you and your family members can never stay in this property. It must be investment real estate.

The following is not an exhaustive list, but simply a highlight of some of the restrictions associated with this option:

  1. Most large and well-known custodians don’t allow you to own real estate in an IRA. Those that do tend to be smaller and less well-known, and may charge high “maintenance” fees.
  2. It’s very difficult to get a mortgage on a property that is owned by your IRA. You will likely need to buy the real estate in cash, which reduces the amount of property you can afford.
  3. You cannot help with the operations of the property (e.g., finding tenants, doing repairs, etc.). You must hire a property manager to oversee the tenants, and hire a contractor for repairs
  4. All income generated from the property must be deposited back into the IRA. In addition, all expenses related to the property must be funded from the IRA, which means you’ll need a sizable cash buffer in the account.
  5. Owning real estate in an IRA makes it’s difficult to work around the IRS’ rules for “required minimum distributions” (RMDs) when you are over age 72 (unless the account is a Roth, which doesn’t have RMDs). These rules require you to withdraw a certain amount per year. But if the account holds real estate how do you do that? You can’t just sell a small piece of the property. And the penalty for not complying with this rule is serious: a 50% penalty on what you should have withdrawn (e.g., if you were supposed to withdraw $10,000 and you didn’t withdraw anything, you’d be fined $5,000). Again, a large cash buffer is required. Importantly, RMDs increase as you age, which may force you to sell the property if you do not have enough cash within the IRA to fund your RMD.
  6. By owning real estate in an IRA you lose a lot of the traditional tax benefits of owning an investment property, such as the ability to depreciate it, deduct the mortgage interest, or deduct the property tax. On the other hand, you’re not paying tax on the rental income that the property produces.
  7. If you are able to secure a mortgage, you will likely pay “unrelated business taxable income” (UBTI), as income generated from leveraged property is taxed at individual income tax rates. And paying tax may decrease the attractiveness of owning real estate in an IRA. If you do owe tax, it must be paid by your IRA.

If a rule is broken, the full value of your IRA can become fully taxable, plus an additional 10% penalty may be assessed depending on your age.

It’s also worth noting that rental real estate typically qualifies for a “1031 exchange.” This provides a tax break that allows for the deferral of capital gains tax on the sale of a property indefinitely, or even a portion of that gain if someone needs some extra cash liquidity through time. In addition, it may be possible to eliminate the tax created by rental income through the combination of debt and depreciation. In fact, too much debt can actually create losses that can’t be taken on a year-by-year basis.

Based on our assessment above, there are many hurdles to purchasing real estate in an IRA. It’s most beneficial if you: a) have a large IRA that you do not need to produce retirement income from, b) are intent on owning an investment property, c) have enough money to buy a property without a mortgage, and d) still have enough cash left over after acquiring it to cover ongoing and unexpected expenses.

While the tax benefits of owning real estate in your IRA are appealing, the right qualifications are relatively rare.

Written by: Will Steinberger

Please note that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk. Therefore, it should not be assumed that future performance of any specific investment or investment strategy (including the investments and/or investment strategies recommended and/or undertaken by Opes Wealth Management) will be profitable.