IRA Real Estate –a Bad Idea
Even with the bloom off the rose, investors still have interest in using real estate in IRAs. The interest and use of real estate in IRAs peaked with prices. Even as the real estate market cratered, real estate professionals with sagging commission income pushed IRA real estate (often mistyped or incorrectly searched as IRS real estate) on investors dissatisfied with stock market returns. But IRA real estate is a bad idea for IRA savings. Here are five reaons why real estate is a bad idea for tax sheltered retirement investing.
You lose the depreciation deduction. One of the nice things about owning apartments or rental homes is that the cash flow is partially sheltered from income tax by the depreciation deduction. Since an IRA does not pay current tax, IRA real estate loses the deduction. Why would someone knowingly lose a tax deduction? Because they are likely sold on the idea of real estate in IRAs by a zealous real estate sales person. Or, they may only have liquidity in their IRA and no cash outside their IRA. If you don’t have the cash outside the IRA, then pass on an IRA real estate purchase.
You lose financial leverage. When you purchase real estate outside of an IRA, you can typically put 20% down and borrow the rest. So when the property appreciates 20%, you have doubled your investment–a 100% return on your equity. But an IRA real estate purchase cannot be done with any mortgages as IRAs cannot have debt. So you must make the purchase for all cash. Now, when the property appreciates 20%, you have a 20% return on your money, not 100%. Therefore, you lose the leverage of “other people’s money” when you consummate an IRA real estate purchase.
You turn the best capital gains asset into ordinary income. Because of the leverage explained above, you can have very large capital gains on real estate. Not only do you lose the large capital gain potential because of losing leverage, you have turned a capital gains taxed at reduced rates (15% to 25% on real estate), into ordinary income (rates as high as 35%). There is not such things as capital gains on IRA real estate because everything withdrawn from an IRA is taxed as ordinary income.
If the rental property in your IRA needs a new roof, you must use IRA funds to replace the roof. You cannot use your own funds as then you as an individual are deemed to be in business with your IRA and this is a prohibited transaction which could cause your IRA to become taxable. So you need to always have plenty of cash in your IRA for repairs, insurance payments and property taxes. This means you need to keep funds liquid in 1a 3% money market and sacrifice the potentially higher returns of other investments. Need yet another reason?
Your IRA fees are likely free at your brokerage firm or bank. To hold real estate in IRAs, you need a specialized IRA custodian willing to do this and the fees range from 40 to 150 basis points annually–i.e. hundreds of extra dollars in costs.
And just in case you still want IRA real estate, if you should make a bad deal, your loss will not deductible inside an IRA as it would be as a non-IRA transaction. If you line up 10 people that tell you placing real estate in IRAs is a good deal, you will find 10 people that earn commission by selling real estate. If you want real estate in your IRA, then buy shares of real estate investment trusts or other real estate securities.
December 10th, 2008 at 3:00 pm
I guess I’ll start off with the fact that I am a real estate professional that specializes in IRA real estate purchases. Why? Because real estate is an EXCELLENT investment to hold within an IRA. Let me give you 5 reasons why.
1) Create Leverage: Your IRA can absolutely borrow money! National American Savings Bank (www.nasb.com) is one lender that does non-recourse loans to IRA holders. They usually require 30% - 40% down and want to see positive cash flow in any deal, but you can create leverage with an IRA. By the way, you could also borrow money from another IRA holder since lending money is also allowed by law.
2) Tax Free Cash Flow: A successful real estate investment can provide monthly cash flow to help grow your retirement along with any appreciation earned in the property itself. Since the asset is held within a tax-free environment, there are no taxes to worry about. Any profit withdrawn from the IRA is income based on your tax rate upon withdrawal. And since you’re in retirement, your taxed at a lower tax rate based on the limited income you make. And if you own the asset in a Roth IRA, the monthly cash flow and capital gain are TAX FREE.
3) Control: Want to improve the value of your investment? Add a new roof. Put in carpet. Do landscaping. Add new fixtures. All of these improvements can increase monthly cash flow and ultimately improve the value of your asset. These costs do get paid out of your IRA, but name another investment class that you can improve with your own free will. If you own mutual funds, CD’s, stocks, you’re along for the ride and your return is completely independent of your effort. Not so with Real Estate.
4) Inexpensive Custodian Fees. Self Directed IRA custodians get paid based on the size of your account, usually 40 basis points or less. So if you have a $100,000 account, your annual fee is in the $450 range. But that’s it. Other banks and brokerage houses don’t charge you a fee because they make their money from the limited investment products they offer. Own mutual funds? Their fees can include management fees, redemption fees, exchange fees, account fees, purchase fees, distribution fees and operating expenses to name a few. Usually these fees are TWICE as much as what a self-directed custodian will charge.
5) Diversification. Real estate offers a great way to diversify your portfolio. How many people had ALL of their retirement portfolio in the stock market? Nearly 70%. Use real estate as a way to generate leverage, produce monthly cash-flow and long-term appreciation. But also use it to balance your retirement portfolio, along with other asset classes, so retirement doesn’t get postponed due to a bear or down market.
I offer that if you find 10 people who advise against real estate in your retirement account you’ll probably find 10 people that LOSE money when their clients shift assets to a self-directed account and out of their control.