By Asking The Right Questions

AVOID THESE IRA MISTAKES

By Asking The Right Questions

IRAs have become popular as a means to save and invest for retirement.  They can also provide a tax deduction.

People have learned that they can transfer retirement funds from old 401(k) accounts to IRAs that they control.

Some savvy investors have learned that they can purchase real estate within their IRAs and solo-401(k)s.  But should they?  Receiving a personal benefit from a property held in an IRA could trigger an early distribution and penalty.  Personally performing work on a property in an IRA is considered making a contribution and has consequences.

There are pros and cons to owning property in an IRA.

First, let’s take a look at some of the pros.

ADVANTAGES TO OWNING REAL ESTATE IN A RETIREMENT ACCOUNT

There is a potential to obtain higher returns over time.  Overall, properly leveraged real estate tends to produce higher returns over time than the stock market.  Even without leverage, a distressed property can be purchased, rehabbed, and put into service.  This strategy alone can significantly increase the returns within a retirement account.

Control over the investment.  Depending on your level of involvement, you can make management decisions.  You get to decide where and what to buy, who your target rental market is, what level of renovation is appropriate within your market, and more.  You can, and probably should, choose a property manager to manage the property.  You get to choose the investment but don’t have to be involved with day-to-day decisions.  The investment might even be a partial interest in a property owned with other partners.

Ability to provide a cash flow stream.  This may be tapped as an income source, or used later when you are required to take Required Minimum Distributions.  If your alternative is investing in the stock market, ask yourself how you feel about selling stock in a down market just to take RMDs.

DISADVANTAGES TO OWNING REAL ESTATE IN A RETIREMENT ACCOUNT

There are a number of disadvantages to buying real estate in a retirement account.  But that does not mean your IRA should not buy real estate.  You need to be aware of the restrictions and weigh them against the advantages.  Some of these may be real concerns, while others may seem trivial.

You cannot use your personal funds or credit for assets within the retirement account.  So borrowing funds to purchase a property typically requires using a non-recourse loan.  These are typically limited to 50-percent loan to value.  Non-recourse loans usually carry a slightly higher interest rate than other investor loans.

Leveraged property held in an IRA is subject to tax under UDFI, or Unrealized Debt Financed Income.  Sometimes this is referred to as UBIT, or Unrelated Business Income Tax.  The tax liability is based on the loan to value of the property and is prorated based on this leverage.  Leveraged property held in 401(k) accounts is not subject to UDFI.

Some people argue that you can’t use depreciation losses to offset income outside of the retirement account.  This is really a reason to purchase real estate outside of a retirement account, provided you have the funds to do so.  But if the money is stuck inside a retirement account, the better question to solve is how to obtain the greatest return with the given funds.

Passive rental income and capital gains are turned into ordinary income, which is taxed at higher rates when distributions are later taken from the account.  Of course, this also happens with IRA and 401(k) investments in the stock market.  Many stocks and mutual funds report a combination of long-term and short-term capital gains that get taxed differently if held outside of a traditional retirement account.  This is really a reason to use Roth retirement accounts for investing as opposed to Traditional retirement accounts.

You need to have sufficient reserves in the account to cover unexpected costs.  How much does a turnover cost when a tenant leaves?  How much does it cost to replace an air conditioner?  How do you handle $20,000 in repairs if you only have $10,000 cash in the retirement account?

You can’t pay expenses with personal funds.  No, you can’t put an expense on a personal credit card and pay it with the IRA.  All expenses are paid directly from the IRA account.

You cannot have personal use of the property.  This includes use by your parents, spouse, and your kids.  So buying the beach property or mountain cabin in your IRA will prohibit you from using it legally.

You cannot personally do any work on the property.  This is not necessarily a bad thing, because as investors we should be spending our time finding opportunities and investments rather than making repairs.  But some landlords like to make their own repairs and take the opportunity to make an unscheduled inspection.

Travel expenses and business meals can’t be paid from the retirement account.

WHAT QUESTIONS SHOULD WE BE ASKING?

The list of pros and cons can get confusing.  But a few things are very clear:  

1. Roth accounts are better than Traditional retirement accounts because you can get tax-free income in the future.
2. 401(k) accounts can allow leveraged purchases without being subject to UDFI.
3. Depreciation and passive losses from property held outside of retirement accounts can offset other income and reduce tax liability.

Here are some of the questions that help in making an investment decision.

One.  What investments provide the best total return?  Employer-sponsored retirement plans typically limit investment choices.  Leveraged real estate can provide superior returns.  This can be accomplished in a number of ways such as buying single-family houses or partnering with others on an apartment complex.

Two.  Where is the money now?  For example, is it in a traditional IRA?  Or a 401(k) at a previous employer?  Is it a Roth IRA or Roth 401(k) account?  Or is it outside of any retirement account?  If possible, consider converting any Traditional retirement account funds to Roth accounts so that future earnings are not taxed at higher ordinary income rates.  It might even make sense to take an early withdrawal from an IRA to purchase property.  David found the early distribution penalty to be less than his expected gains when considering where to get funds to purchase a recent apartment complex.

Three.  Are you seeking to maximize growth, income, or a combination of the two?  Leverage can help maximize long-term growth, while private lending may provide a steady income stream now.  Paying off a mortgage over time is one way to move gradually from a maximum growth strategy to one emphasizing cash flow.

Four.  How active do you want to be in the investment?  If you want to swing a hammer or do any work yourself, then buying a property inside an IRA is not likely a good idea for you.  On the other hand, if you want the benefits of investing in real estate but do not want to be an active participant, there are many opportunities both inside and outside of retirement accounts.  From private lending, to owning property and hiring a property manager, or becoming a passive investor in a real estate partnership.

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