I recently received a postcard inviting me to a free dinner to attend a presentation where the speaker was going to explain how to purchase real estate inside of an IRA. The receipt of this invitation really irritated me. While the tax law allows a taxpayer to purchase real estate within an IRA, I doubt that the speaker was going to share with the audience why that may not a good idea. When these types of investment opportunities surface, we encourage our tax preparation clients to seek our tax planning advice before making any financial commitment.
Why are these types of investments fraught with dangers? Let’s start with the potential for a prohibited transaction. If there is ANY personal use of the real estate property, you have a prohibited transaction. If an IRA owner engages in a prohibited transaction, the IRA is disqualified and the ENTIRE IRA account balance is deemed to have been distributed to the IRA owner effective as of January 1 of the year that the prohibited transaction occurs. The IRA owner has now inadvertently converted a tax deferred account into a taxable event. If the owner is under age 59 ½, the additional 10% early distribution penalty will be applicable and tax underpayment penalties may also be due the IRS. For those investors who say that they will not use the property for personal use, the tax code is fraught with tax land mines. We had one client who had a resort rental property within her IRA and wanted to know if it was a prohibited transaction if she slept in her property while she did repair work on it. Legal counsel opined that sleeping in the property was personal use and that would be considered a prohibited transaction. Other examples of a prohibited transaction include situations where the real estate is purchased with a loan and the IRA owner personally guarantees the loan or obtains a recourse loan.
Another major problem with these real estate IRAs has to do with cash flows. The IRA must have sufficient cash reserves to pay for improvements (new roofs, heating system, etc.), repairs, taxes, debt service, HOA fees, and all the other costs associated with home ownership. If the IRA owner is depending upon rental income to pay for these expenses, he must keep in mind that these operating expenses will be incurred every year, whereas rental income depends upon market conditions. Plus any major capital improvement may require a significant cash outlay in a year. Since real estate is not a very liquid asset, for how many years must the IRA pay for these expenses?
There are hidden costs associated with real estate in an IRA. The IRS requires that an annual valuation of the IRA’s fair market value be reported each year on IRS Form 5498. The IRA custodian may require that an annual appraisal be done. This appraisal must be paid by the IRA.
There are also other tax considerations that the presenter likely would not share with his audience. If the real estate must eventually be sold, will its selling price be at a market peak or trough? Had the property been held outside the IRA, gains on the sale would have received capital gain treatment whereas all distributions from an IRA will be taxed as ordinary income. Losses on the sale, if held in an IRA, usually do not generate any tax benefit whereas if held outside the IRA would generate a long-term capital loss. When the IRA owner reaches the age of 70 ½, required minimum distributions (RMDs) are required to be made from the IRA. Does the IRA have other IRA funds from which the RMDs can be paid or will the owner be forced to sell the real estate at an inopportune time?
If you want to learn more about your personal tax situation and how competent tax professionals can benefit you, we invite you to call 610-594-2601 today to make an appointment at our Exton PA CPA office to discuss your situation. You can also schedule a consultation at Click Here.