When people think of investing in an IRA (Individual Retirement Arrangement), most people think of stocks, bonds, or mutual funds. Through the use of a self-directed IRA you can use the funds in the IRA to buy real estate for investment purposes.
IRAs
Traditional IRAs are a means of deferring taxes to a later date. This can be beneficial for those that will be taxed at a lower rate in retirement than while working. This may be the case if you make only 60% of your current salary in retirement.
This vehicle allows for taxes on assets inside the IRA account to be deferred or postponed until the money is withdrawn from the IRA account. Hopefully, this generates a higher return for the investor because they are not giving money to Uncle Sam on all of their investments. For instance current income from bonds is not taxed now, allowing it to be reinvested for a higher return. Realized appreciation or capital gains tax is deferred until the money is withdrawn from the IRA allowing you to invest what you would have paid in taxes to generate a higher return.
Self-Directed IRAS
What is a self-directed IRA? A self-directed IRA allows you to use the expertise you have to improve your investment return. This is a great means for real estate investors to capitalize on the knowledge that they have. Taxes on appreciation and rental income can be deferred until a later date, thus allowing an investor’s portfolio to grow at a faster rate.
Most brokerages will tell you that their IRA is self-directed; by this they mean that you personally can choose the stocks, bonds, or mutual funds that you invest in. However, if you ask them if you can invest in a single real estate property they will probably tell you “No”.
A few trust companies have set up their IRAs so that you are allowed to invest in a single property. Equity Trust Company of Ohio and Pensco Trust Company of San Francisco are two such companies that allow the purchase of real estate in an IRA. You can buy property, invest in real estate secured loans, or even fund someone else’s mortgage from your account.
Prohibited Transactions
There are some specific rules regarding what is allowed and what is not allowed inside of an IRA. IRS Publication 590 outlines the rules and regulations regarding IRAs. These types of transactions cause the account to lose IRA status as of the first of that year and all the assets will be distributed to the owner. Taxes are due on any amounts above the basis in the account.
The IRS defines a prohibited transaction on page 45 of IRS Publication 590 as follows:
Generally, a prohibited transaction is any improper use your traditional IRA account or annuity by you, your beneficiary, or any disqualified person.Disqualified persons include your fiduciary and members of your family (spouse, ancestor, lineal descendant and any spouse of a lineal descendant).
The following are examples of prohibited transactions with a traditional IRA:
- Borrowing money from it.
- Selling property to it.
- Receiving unreasonable compensation for managing it.
- Using it as security for a loan.
- Buying property for personal use (present or future) with IRA funds.
So you cannot use your IRA to buy a vacation home or a house for a child. You also cannot sell your current house to your IRA. For safety’s sake, it also means that you should not serve as manager of a rental property held inside your IRA. You cannot do repairs or rehab on a property yourself. The IRS will likely treat this as a contribution because you personally are “adding value” to your IRA.
Who Should Use a Self-Directed IRA?
A self-directed IRA is good for someone in the accumulation phase of wealth building. This phase is prior to actual retirement when an investor is accumulating assets to use as income during retirement. IRAs are not the best option for those in retirement because distributions from the account are taxable as income.
It is also a good choice if you have an existing IRA or a 401(k) from a previous employer. Frequently, these existing accounts can be rolled-over into an IRA without affecting their tax status. The IRS limits traditional IRA contributions to the lesser of $4,000 ($5,000 if you are over 50) for 2006 or your taxable compensation for the year. It would take a few years’ worth of contributions to accumulate enough wealth to invest in real estate. (SEP and SIMPLE IRAs allow self-employed owners to contribute more to their IRAs. You should talk to your tax advisor about the benefits of these accounts.)
These accounts are useful for people that have an existing IRA, but are unsatisfied with the current returns produced by conventional investments. By investing in high quality real estate, the IRA owner can use their specific knowledge to improve the return on their retirement assets.
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