Real Estate in Your IRA-Are You Kidding?

When the stock market started to swoon and real estate started to boom, some investors turned to special self-directed IRAs to invest in real estate. To begin with, most conventional custodians, even those that allow you to choose between stocks, bonds, ETFs, et al, will not allow non-publicly traded securities in your IRA. Special custodians are necessary to own those assets. Now, although the real estate market is slow, there may be still money to be made.

Recently, a national publication led with a story about an IRA investor who took a 30-day option on a residential property and sold it before the option expired for a $175,000 profit. In April, I spoke at an investment management conference in New York City where this same topic was brought up repeatedly. Except in very infrequent situations where properties can be flipped quickly (which has become especially rare in this market), most real estate investments are long term and eligible for special tax treatment. This particular transaction was the exception, not the rule.

So, let’s look at a more typical income earning investment property, and I will even allow for a positive return and a 7% annual income-net of operating expenses. Should you own it in an LLC (Limited Liability Company) or should it be part of a retirement account? I never recommend that investors, especially physicians, have direct unprotected ownership of a large asset.

Since it’s an investment property, a real estate property would normally be subject to depreciation, a good tax write off that would shelter some, if not all, of your cash flow. However, no depreciation is allowed in an IRA, so that tax benefit is lost. Normally, when you sell it, property, the proceeds would qualify for a 15% long term capital gain. That tax benefit also would be lost in an IRA. What if you leave it to your heirs? If you take this approach, IRAs have no step up in basis, so that tax benefit would also be lost. And if things went poorly, you could not write off any losses. All in all you would lose most of your tax benefits. That doesn’t sound so good to me.

To make matters worse, if you had to make improvements on property in a self directed IRA and there was not enough cash to do so, it would be very difficult to borrow from the property. If you put money into the property directly, that would be deemed to be a contribution and in that case, it could disqualify the IRA. All of the IRAs tax deferral would disappear in the blink of an eye. In fact, the entire IRA could become taxable as ordinary income in a single year, about the worst possible problem you could create in a qualified account.

Am I saying that real estate is a bad investment? No, but how you own real estate will have a significant effect on your taxes and profitability. I believe quite strongly that an IRA is not the right place to own non-publicly traded real estate or any other asset that is not liquid.