When you put a rental property (a house, condo, land, or even commercial property) in an IRA, you don’t owe taxes on the income it earns while your retirement account grows. Here’s how it works:
You use $100,000 that’s already in an IRA account to buy a rental home. (In this example, we’re assuming for simplicity this is the full price. You can get a mortgage for real estate inside an IRA, but there are special rules. More on that later.)
The rent is $500 a month. Every year, your investment property earns $6,000 less expenses of $3,000, netting you $3,000 per year.
You keep that $3,000 inside your real estate IRA each year. Prudent, conventional investments allow it to grow at about 3% a year.
In 20 years, you turn 59½ and can start taking money out of your IRA.
You’ll have about $82,000 in your investment account (compounding $250 per month for 20 years) and the house will be worth about $180,000 (assuming home prices rise 3% a year and you never raise the rent).
Just like a traditional IRA, you have to follow the IRS rules about what you can and can’t do with it. Since it’s easier to accidentally break the rules than if you just have stocks or mutual funds, and the IRS hasn’t given a lot of guidance, work with a qualified financial adviser, CPA, or attorney who specializes in tax issues.
As you sift through the details, keep three rules of thumb in mind and you’ll be fine:
1. Everything in the IRA stays in the IRA. The real estate, and any income it generates, stays inside the IRA — at least until you turn 59½, when you can legally start taking out money.
2. Everything outside the IRA stays outside the IRA. No money from accounts other than this IRA can be used to buy or improve IRA-held real estate, or pay the property’s mortgages, taxes, and insurance.
3. You’re always one step removed from your IRA real estate. You can’t live in it. Do it and the IRS says, “Hey, you’re enjoying your retirement account before you retire.” That’s like pulling cash out of your IRA before you reach the magic age of 59½. And that means penalties. Also, only non-related contractors can work on it, and they must be paid with IRA cash. Likewise, if you sell the property before you turn 59½, keep the money in the IRA or you’ll pay penalties and taxes for early withdrawal.
1. Say good-bye to typical home tax deductions. Your house is already inside a tax-advantaged account, so you don’t get to deduct the mortgage interest or other expenses. If you pay cash for the property, that’s no big deal. But if you have a mortgage, mortgage interest is a big deduction to lose.
2. What if your property doesn’t generate a profit every year — perhaps the tenant is late on payments or the property is vacant for periods of time? You’ll need a cushion in your account to draw on.
3. You can’t deduct losses, such as from storms, because the property is in an IRA. Similarly, if the property is sold for a loss, you can’t deduct that. And when you take money out of the real estate IRA, it’s taxed as income. But when you own the property outright and sell it, the profit comes under the rules for cap gains, which means your profit is likely excluded from tax.
Get a custodian. The companies that run typical IRAs avoid exotica like real estate. You’ll need a specialized company to help run a “self-directed” IRA where you put your rental property. Self-directed means you take more responsibility for your investment than you would typically. Here are a few custodians that let you expand into self-directed options like real estate, in addition to typical IRA investments.
The self-directed IRA isn’t a different animal, really. All the advantages and rules of a traditional IRA apply. And since you’ll need IRA cash to manage your IRA real estate, it’s much simpler (although not legally mandatory) for you to have all IRA holdings — real estate, money market, stocks, mutual funds — with one custodian in a single self-directed account.
Costs are comparable to a traditional IRA, but as with any investments, fees can vary, as can charges for services. It pays to shop around — ask potential custodians for free breakdowns.
Repairs: If your rental isn’t making enough money to cover repair costs like leaky faucets or broken furnaces, tough luck. You can’t pay for the repairs out of your own pocket.
Upgrades: A DIY upgrade is verboten because you’re contributing something of value (your labor) to the IRA, says Kevin Worthley, a financial planner who specializes in retirement planning. Still, if you personally fix a faulty electrical outlet, for example, you could argue that you aren’t adding to the house’s value, merely maintaining it, so that should pass muster with the IRS.
So does that mean you can never fix up your IRA house? You can turn it into a palace if you want — but you can’t do it yourself. Hire contractors, and pay all their fees from inside the IRA. If you have $1 million inside your IRA, go right ahead and buy a $500,000 house and spend $250,000 to improve it, leaving yourself a plentiful cushion. But you can’t spend one dime out of your regular income or personally do anything more elaborate than change a washer in the faucet.
Solution: Keep a cash cushion in your real estate IRA to cover unexpected repairs and vacancies. How much? Think of what you do for your primary residence and match it for your rental. Make a list of the costs of your rental taxes, mortgage, and upkeep if you have to go for an extended period without a tenant.
Get a special real estate IRA mortgage. If you’re not planning to buy a rental property outright with existing IRA funds, you’ll need a non-recourse loan. That literally means the bank has no (or virtually no) recourse if you default. If you stop making payments on a non-recourse loan because your IRA runs out of cash, the bank can’t force you to pay the mortgage with non-IRA money. (That would break the law by commingling regular funds with IRA funds.)
Since a non-recourse loan is a bigger risk for a bank, it will want a 30% or larger down payment (from your IRA account, not your personal bank account), and you’re going to pay a higher interest rate by several points than you would for your regular home loan.
Other than that, the mortgage works like any other:
Instruct your custodian to draw checks from cash inside your IRA to the bank.
Or have the custodian set up a regular electronic transfer. The custodian will also do this for real estate taxes and insurance.
As long as the IRS sees that all home-related payments come out of the IRA account, you’re fine.
So What Happens When I Retire?
At 70½, you must start taking a certain minimum out of your IRA regularly, so you need enough cash on hand to pay yourself. Make sure you have this cushion well before you hit 70½. You can also sell the IRA house and put the cash into a more liquid investment.
Here’s another option: When you turn 59½, you can legally take your house out of your IRA. The investment that generated tax-free income all these years is now your cozy retirement cottage. Of course, you have to pay income tax on the home’s value, but if you sold your primary house, you now have the cash to do that, so you’re set for your golden years.
Or, at 59 1/2 you can create a series of deeds that gradually transfer your house to you personally while leaving some of it in your IRA, before you actually move in. This stretches out your income tax liabilities because you’re basically taking only a piece of your house out of the IRA each year. You need a lawyer and title company to do this, but if you want to avoid a large tax bill in your first residence year, it’s worth it.
This article provides general information about tax laws and consequences, but shouldn’t be relied upon as tax or legal advice applicable to particular transactions or circumstances. Consult a tax professional for such advice.
Richard Koreto is a freelance writer. He's been editor of many financial magazines and is the author of "Run It Like a Business," a practice management book for financial planners. He and his wife own a pre-Civil War house in New York.
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