Most of us think of an IRA as a place to invest in mutual funds, stocks and bonds.  However, you may have heard that investment real estate may also be purchased in an IRA.  The rumors are true- you can, but with a few complications and drawbacks that are likely the primary reasons this strategy has not gained widespread use.  Nonetheless, IRA real estate investing may prove beneficial to your particular situation, so it's definitely worth a conversation with your financial planner and CPA.

One obstacle is that IRA real estate investing must occur through a self-directed IRA and is generally not available with the vast majority of major wirehouses and other recognizable name brands in the investing world.  However, if you logon to Google and enter "Real Estate IRA" or "Self-Directed IRA" you'll see there is no shortage of suitors who will be glad to help you transfer your existing IRA funds to a self-directed IRA.

The second complication is the need for nontraditional sources of mortgage financing.  Larger banks and mortgage companies typically will not lend on real estate held in an IRA because title to the property is held by the IRA trustee rather than the IRA owner.  You'll need to look for a niche lender that offers this type of financing, which will most often be a smaller local bank or credit union.

Finally, you'll also need to partake in an analysis of whether the pros and cons of IRA real estate investing make sense for your personal situation.  This should definitely entail discussions with your financial planner and CPA, but for starters here are some of the considerations you should look at:

Pros:

• Better Diversification- if most of your investments are tied up in the stock market then this is a terrific solution for diverting some of your money into real estate to give you a more balanced portfolio.
• Active Investment- for those of you who are more inclined to managing your own investments, buying real estate is the best solution available for an IRA.
• Deferred taxes.  Speak with your CPA about how this will affect you, but in general you will be able to defer taxes on all income and capital gains.
• Use of leverage- There aren't many IRA investments you can leverage to potentially increase returns, but this is one of them.

Cons:

• Less favorable mortgage terms- Expect a minimum required down payment of 30% to 40% and an interest rate that exceeds the standard rates for investment properties by 0.25% to 0.5%.
• Tax disadvantages- believe it or not, the tax deferral strategy could backfire.  With a traditional IRA account, you'll have to pay the taxes someday.  If income taxes in the future are higher than they are today then you'd be better off paying the taxes today.  Also, the sale of property may generate unfavorable consequences- NON-IRA long-term capital gains are currently taxed federally at just 15%, but all IRA gains will eventually be taxed as ordinary income.
• Profits are inaccessible- while taxes on all gains and income are deferred, all profits must be kept within the IRA until age 59 ½ to avoid penalties.

In a nutshell, the drawbacks of IRA real estate investing wash away many of the benefits.  Keep in mind that purchasing real estate outside of an IRA still makes for a very tax advantaged investment with depreciation deductions and 1031 exchanges available. 

The IRA real estate investment seems to be most appropriate for middle aged and older investors whose primary net worth is held in an IRA.  If you are 50 years old and you have $500,000 in an IRA but little else in outside investments, it's likely that the only capital you have available to purchase investment real estate is that in your IRA.  Rather than keeping all of your investment exposure in the stock market and rather than paying a penalty to liquidate a portion of your IRA to buy real estate, using your retirement savings to purchase real estate within your IRA gives you the opportunity for greater portfolio diversification without patently unfavorable tax consequences.

If you have available investment capital both within and outside of your IRA then it's debatable as to whether making the purchase within the IRA makes sense.  In all cases, meet with a financial planner and CPA to dig into the details of how this decision will affect your long-term financial situation.