When most people think of IRA investments, they typically envision stocks, bonds and various types of mutual funds. Relatively few seem to be aware that real estate investments can also be included in an IRA as long as the IRA is "self-directed' and IRS requirements are met. Key advantages of including real estate investments in self-directed IRAs (SDIRAs) are diversification and the deferral or elimination of taxes on annual investment income and gains from sales.
The number of SDIRAs has doubled during the past five years. The Wall Street Journal (April 2012) reported that the Retirement Industry Trust Association estimated that $4.6 trillion was held in IRAs in total, with 2 to 5 percent invested in SDIRAs.
In general, there are two types of IRAs (SDIRAs included) - traditional and Roth. Investments in traditional IRAs are tax deductible; tax on all earnings is deferred until the earnings are withdrawn; and all withdrawals are fully taxable at ordinary tax rates (which presently range from 10 to 39.6 percent), even if the withdrawals are associated with gains from the sale of assets. Thus, the capital gains tax rate does not apply.
Penalty-free withdrawals are allowed to begin at age 59 1/2 but must begin at age 70 1/2. In sharp contrast, contributions to Roth IRAs are made with after-tax dollars (that is, they are not deductible), but all withdrawals, including annual earnings and gains from sale, are tax-free. Also, withdrawals are not required.
Annual contribution limits for any type of IRA (including both traditional and Roth SDIRAs) can be as low as $5,500 but may be higher for any IRA-type plan that small businesses offer their employees. Large balances in SDIRAs may be created through annual contributions made over many years, rolling over funds from other IRAs and/or rolling over traditional/Roth 401(k) plans when employees retire or move from one employer to another.
Most IRAs are administered by large investment houses, banks, and savings and loan institutions. Investments in these IRAs are typically required to be stocks, bonds, mutual funds and similar investments.
The only way to hold income-producing real estate in an IRA-type plan is to create an SDIRA. To do so, the investor must locate an SDIRA custodian/trustee approved by the IRS who will allow the investor to invest in real estate. Such custodians may be found via the Internet and may be a local firm or a large national firm that specializes in SDIRAs. There are very few large firms, but they are easy to find online.
Various types of fee arrangements exist for SDIRAs - flat fees, fees based on fair market value, or a combination. Annual administration flat fees may range from $250 to more than $1,500 depending on fair market value (FMV). Some annual fees reflect the number of properties held in the SDIRA. Annual FMV percentage fees may range from .4 percent to 1.5 percent of FMV, according to the Wall Street Journal (April 2012).
Other fees may be charged for each transaction (each SDIRA contribution as well as each property acquisition or sale). Also, there may be restrictions on the number of real estate trades in a given year. In contrast, some SDIRAs are referred to as "checkbook" SDIRAs and literally enable investors to write a check to purchase SDIRA assets (see restrictions that follow). Investors need to perform due diligence and carefully compare SDIRA custodian arrangemnts.
Another set of critical issues pertains to the strict IRS rules governing SDIRAs. The only debt allowed to be in SDIRAs is property acquisition debt. Transactions are not allowed to take place between relatives and the SDIRA. The SDIRA owner may not sell the SDIRA assets he or she owns outside the SDIRA. Other prohibitions preclude 1. SDIRA investments in the SDIRA owner's (or a relative's) personal, 2. using the SDIRA as collateral for a loan and 3. receipt by the SDIRA owner of compensation associated with an SDIRA asset. As with all tax-related transactions, careful record-keeping by the SDIRA owner and/or the custodian is crucial. Running afoul of IRS requirements could bring about penalties, immediate taxation of SDIRA funds and possible termination of SDIRA tax-preferred status.
Thorough investment analyses are as important for SDIRA real estate investments as any other real estate investments. For specific advice, consultation with a tax accountant or tax attorney is recommended.
The Takeaway
Self-directed IRA investments in income-producing real estate may provide significant advantages such as tax tax deferral, tax-free income and diversification. Tax and nontax complexities require due diligence before establishing an SDIRA.
By Jerrold J. Stern
Stern, Jerrold J. "Real Estate Investments and IRAs". Tierra Grande Journal of The Real Estate Center at Texas A&M University. January 2014: 23.
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