Forty-six million taxpayers have some type of Individual Retirement Account (IRA), collectively holding more than 2.5 trillion – yes trillion – dollars. In 2000 alone, more than $36 billion was added to these accounts. That’s a lot of nest eggs.
The majority of these funds are invested in traditional investments such as stocks, bonds, mutual funds, CDs and annuities. So, it may come as a surprise to learn that IRA funds may be invested in almost anything, including real estate, partnerships, Limited Liability Corporations (LLCs), small businesses, loans, etc. In fact, there are only three types of investment specifically prohibited by the tax code: stock of an S-corporation, life insurance and collectibles.
Less surprising is the speed with which IRA owners are embracing these other investment choices. The meteoric rise in real estate values in Nevada has caused many investors to rethink their IRA investment strategy and look for opportunities to put those funds into alternative asset classes. Many investors who owned real estate outside their IRAs over the last few years are looking to garner the same kind of gains inside their tax-protected accounts in the future.
The real estate transaction using IRA funds is similar to other real estate deals, but comes with some special considerations. For example, if an IRA owns a rental property, it is responsible for all the expenses associated with that property, including taxes, insurance, maintenance, etc. These bills may not be paid by the IRA owner with personal funds. So, account owners must ensure that the IRA always has enough cash to cover its own expenses.
Another restriction is that the account owner is not able to use the property personally. For example, an IRA can own a vacation home on a lake and rent it out throughout the year, but the IRA owner cannot use it or rent it. Rules also prohibit certain people from selling/buying property to/from the IRA. They are called disqualified persons and include people such as the IRA owner, his or her spouse, lineal ancestors and descendants, etc. Owners of an IRA cannot sell property they already own to their IRA.
Other combinations are possible however, such as the IRA partnering with investors (including disqualified persons) to buy a property together. A common example is having the IRA buy a share of one of the many development LLCs formed in Nevada every year. These arrangements typically involve many investors buying into a single LLC for anywhere from a few thousand dollars to a few million dollars. The LLC is managed by a developer who takes the total cash raised and completes one or more real estate projects. Any income or capital gains from the project flowing back to the IRA are tax-protected.
Another scenario allows family members, friends or associates to purchase a larger property as partners and use IRA funds from one or more individuals for a portion of the deal. These types of arrangements allow smaller IRAs to participate in real estate transactions when they don’t have enough funds to complete their own deals.
As with any investment type, there are multiple opportunities and pitfalls. This can be a complex area with hoops to jump through to ensure the account is handled correctly within the rules. For savvy investors, it can be a wonderful addition to diversify their tax-protected IRA portfolios.