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 There is not such things as capital gains on IRA real estate because everything withdrawn from an IRA is taxed as ordinary income.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.
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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 is 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? The 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, 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.
December 15th, 2008 at 10:43 am
Nice post.
In my opinion real estate should always be viewed as a financial asset and not necessarily an investment asset.
January 20th, 2009 at 12:38 am
I am a real estate paralegal and I own an abstract company. I have dealt with many new marketing tools in my time and I have to agree that this tool is what you make of it. If you can sell it and make a commision, then you have a leg up. But what about the customer. Did they make a wise investment with the IRA real estate purchase?
January 24th, 2009 at 6:09 pm
Well, I have to say that I agree with you 100% on this one. I’m a realo estate professional and my primary compensation is from comissions. But, I still reccomend to all clients that they shy away from the IRA real estate investments.
I still have morals and honor. And if I don’t think something is good for my clients, then I am up-front and honest with them about it,as all agents should be.
Thanksfor sharing! I look forward to reading more in the future.
January 26th, 2009 at 10:18 am
You made some good points. I feel like there are pros and cons on both sides of this debate of whether or not to use real estate in your IRA. The decision to do it or not should of course be thought over very carefully.
February 4th, 2009 at 10:17 am
This is so interesting! I work for a real estate company and we have been approached by multiple companies wanting to include us in their self-directed IRA presentations. Are they just making money on the transactions? Or transitioning a standard IRA into a self-directed?
February 6th, 2009 at 9:33 am
Hey, you guys are missing something here! There are two different options to using your IRA to buy real estate. One of the ways you can actually occupy the real estate. Read this article by Andrew Waite of Personal Real Estate Investor - its an eye opener! http://www.personalrealestateinvestormag.com/uploads/Articles/IRA%20Nov_Dec%2008%20(3).pdf
February 9th, 2009 at 10:26 am
This seems like a good deal for the real estate reps but a bad deal for the customers.
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February 14th, 2009 at 5:23 pm
I make a living selling a Roth 401(k) plan with checkbook control. Investing in real estate, within our plan, makes great sense! First, unlike an IRA, there is no tax on the profit from leveraged real estate profits. Further, with a Roth plan, all the future profits are distributed tax-free! Having checkbook control makes it so much easier to do repairs and pay for them on the spot.
February 28th, 2009 at 7:09 pm
I have to agree with some of the other comments. I think that real estate is a great long term investment. Even though our economy is in a slump now and the housing market it hurting, it will go up again real estate will always gain value ultimately. However, after all of the bad mortgage loans that were made and ended up causing so many concerns, I don’t think I’d want it in my 401K.
March 31st, 2009 at 1:33 pm
I agree, there are 2 sides to the story. One for the real estate rep and one for the client. I guess we have to find some middle ground here to make it work. Thanks for the article
April 2nd, 2009 at 1:01 am
Well, there are some different opinions in this thread, I guess I just have to look into it myself and come back with my ‘expert’ opinion.
Maverick, you stated that real estate always gains value ultimately, I beg the difference. If counting in all factors, of course you cannot make that statement and fully believe in it.
April 3rd, 2009 at 1:13 pm
Depending on the nature of the real estate investment it can actually end up being more of a liability. But I do agree that it is a better investment than an IRA, especially now with real estate prices at record lows, and the instability of the stock market. Thanks for the read. Great Article.
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April 20th, 2009 at 4:20 am
As I mentioned in an earilier post, I own an abstract company. I have dealt with many new marketing tools in my time and I have to agree that this tool is what you make of it. If you can sell it and make a commission, then you have a leg up. But what about the customer. Did they make a wise investment with the IRA real estate purchase?
April 27th, 2009 at 12:10 pm
Very interesting read - it’s why I love this business… never static and always dynamic. Interesting read but not very objective. Comment from David Coe shows this. Here is to profits!
May 5th, 2009 at 1:06 pm
Real estate just like any other market has it’s ups and downs. with that said real estate is and always will be the most stable investment
May 19th, 2009 at 6:46 pm
As a mortgage broker, I could never advise that someone use their IRA to fund a real estate investment. Maybe I’m just too conservative, but it’s a move that has bad idea written all over it.
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June 19th, 2009 at 5:33 pm
I would invest in reits for a ira not actual income property. This way it is all cash flow and if you use mutual funds you can invest in differnet sectors to make sure your income is steady.
July 1st, 2009 at 1:27 pm
Roland,
Your 100% correct. So many of my clients actually have lost good properties because they overlook the asset part and focus on which property looks to be the best investment.
July 13th, 2009 at 6:00 am
The cost of having a self-directed IRA varies. Some administrators charge according to the total value of assets in the account. For example, if your self-directed IRA is worth $75,000, the annual fee might be 1% or $750. Some firms charge a flat fee per asset you hold in the account, while others charge a transaction fee each time they handle a task for you.Its just way to expensive!!
July 14th, 2009 at 7:13 pm
This is really interesting.. like many have said, 100% agree.. everytime we buy a real estate piece, we should look at it as a long term investment and asset. we should be as educated as possible to be successful in real estate business.
Thanks for the read! Nice one..
KIM
July 15th, 2009 at 12:25 am
The retirement plans/IRA also are often pre-tax withdrawals prior to receiving your after-tax paychecks. Again, a forced savings.Amidst these surviving opportunities to save money for later in life is a growing problem that is happening much too often.It kinda sucks actually..
July 21st, 2009 at 1:07 pm
This has been one of the best conversations I’ve seen on this subject!! Real estate is most definitely an investment, and one that will be with you for many years. So you truly have to look at the long-term benefits and risks. But who knows where we’ll be in 20 years, real estate may very well be the best investment you can make right now.
July 30th, 2009 at 12:38 am
For starters, it’s not always clear who regulates or oversees the entities and people who tout self-directed IRAs. It could be, for instance, a state banking regulator or state securities administrator, or even the state attorney general’s office. Or it could be the Securities and Exchange Commission. The only clear answer is that the regulator is unlikely to be the Financial Industry Regulatory Authority, unless the entity is a broker-dealer. FINRA regulates broker-dealers and stockbrokers.
November 1st, 2009 at 10:22 pm
I am quiet new to real estate but I guess real estate for retirees should be seen as a permanent investment since after they retire, they have to consider questions like: can I still afford to rent? or can I keep up with the constant increase of rentals? money should be invested wisely and although one should not totally invest in real estate, at least you will own a home that will keep your finances stable.
November 6th, 2009 at 1:38 pm
Great article- as more and more people recognize the limits to holding real estate in an IRA the more challenging it is to accomplish! ALthough I sell real estate in Evergreen, CO and prices are through the floor– so a great time to pick up investment property– I recommend purchasing outside your IRA to maximize one of the biggest benfits of buying real estate– Leverage.
November 16th, 2009 at 10:38 am
This is an excellent Post. Thanks!
I believe that real estate should be seen as a financial asset and not an investment asset. This is just my opinion.
November 18th, 2009 at 9:14 am
Which type of IRA investment is best is as subjective as the customer. I love the tips in this article with regards to not breaking any of the rules and causing the IRA to become taxable. Real estate is definitely one of the most stable investments in the long run and should not be ruled out.
December 14th, 2009 at 2:52 am
The only clear answer is that the regulator is unlikely to be the Financial Industry Regulatory Authority, unless the entity is a broker-dealer. FINRA regulates broker-dealers and stockbrokers.ne
January 27th, 2010 at 4:21 am
I’ve got to say that there’s instances where investing in Real Estate in your IRA is a bad idea. On the other hand, there’s plenty of times where it’s a Phenomenal idea. I sure as heck wouldn’t invest them in long-term properties, but short term flipping, I would.
Just depends on where you are in your investing!
February 5th, 2010 at 2:55 pm
Putting the whole property inside the IRA does have disadvantages, like loss of the depreciation writeoff (a big deal) and running into contribution limits to fund expensive repairs. Better yet, have your IRA purchase an equity position (an actual security) in the property, say 25% interest for $30k. No tax on 25% of the profit, and no problems funding repairs. (Experienced professional required.)
February 17th, 2010 at 1:00 am
Real estate is a hands-on investment that demands time and attention. You’ve got to choose the right property, maintain it and find suitable tenants.Dealing with the myriad rules governing IRA accounts makes the task even more challenging.