A little-known IRS provision lets you extend your real estate purchasing with tax-deferred dollars.
Are stock market woes preventing you from building wealth in your retirement account? If so, you might be interested in a small, but growing, trend among individual retirement account owners—investing their retirement funds in real estate.
How It Works
If the option of using tax-deferred funds to purchase property sounds appealing, you'll need to locate an independent IRA custodian that allows real estate investments and work with that company to set up an IRA account. Most banks and brokerage companies—the most common IRA account options—limit your choices to certificates of deposit, stocks, mutual funds, annuities, and similar financial instruments. But Section 408 of the Internal Revenue Code permits individuals to purchase land, commercial property, condominiums, residential property, trust deeds, or real estate contracts with funds held in many common forms of IRAs, including a traditional IRA, a Roth IRA , and a Simplified Employee Pension plan, or SEP-IRA.
Unfortunately, Internal Revenue Service regulations will not let you use the real estate owned by your IRA as your residence or vacation home. Nor can your business lease space in your IRA-held property. The underlying premise for any real estate investment purchased with IRA funds is that you can't have any personal use or benefit of the property. To do so may cost you plenty in taxes and penalties. There are a few other IRS limitations as well. You cannot place a real estate property that you already own into your IRA. Your spouse, your parents, or your children also couldn't have owned the property before it was purchased by your IRA. Property owned by siblings may be allowed, since the Internal Revenue Code (section 4975) specifies that only "lineal descendents" be disqualified.
Operating an IRA-held Property
Because all property expenses, including taxes, insurance, and repairs, must be paid from funds in your IRA, you'll need liquid funds available in your account. Of course, all income generated from the property will be deposited in your IRA account so you can use that money to cover your costs. You also can make annual contributions within federal guidelines. Currently, you can contribute $3,000 annually to a traditional or Roth IRA ($3,500 if you're age 50 or older) and as much as 15 percent of your annual compensation, up to $40,000, if you're a self-employed individual with a SEP-IRA. If your account doesn't have funds to cover property expenses, you will have to withdraw the property from your IRA and pay taxes on the value of the property, as well as possible penalties for early withdrawal. It's also possible to sell properties while they are held by your IRA, so long as the purchaser is not a family member. Once a deal closes, your IRA account now holds the cash proceeds—ready for you to make your next investment. An alternative is to sell an IRA-held property with seller financing so that all payments made by the buyers are paid to the IRA.
Distributing Your Property
You can withdraw real estate from your IRA and use it as a residence or second home when you reach retirement age (age 59½ or older for a penalty-free withdrawal). At that time, you can elect either to have the IRA sell the property or take an in-kind distribution of the property. Under that arrangement, your IRA custodian assigns the title to the property to you. You will then have to pay income taxes on the current value of the property if it's been held in a traditional IRA. If the property was held in a Roth IRA, you won't owe taxes at distribution. This makes a Roth IRA extremely attractive if you anticipate that your real estate investments will appreciate over time. Whether your retirement strategy is to hold properties or buy and sell for gain, real estate investing through your IRA can yield extraordinary returns toward your future retirement.
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