Debunking the fallacies of Self-Directed IRA Investments in Real Estate
What are the common objections to using IRA/401k funds for Real Estate investments?
Here are the truths:
Personal Use Common Objection – You cannot personally use property owned by your IRA.
Correct, though I cannot imagine any investor benefiting from any IRA investment before taking the investment as a distribution. Any benefit to a plan’s owner from an investment prior to it’s distribution would be considered a prohibited transaction, this is not unique to Real Estate investments.
ExpensesÂ Common Objection – You can only use IRA funds for all expenses associated with the property.
True, it is not possible to add funds beyond your annual contribution limits. It is critical that investments in Real Estate using qualified funds are done conservatively with suitable reserves.
Unrelated Business Taxable Income (UBTI) Common Objection – If you purchase Real Estate within your IRA using a mortgage, you may be subject to UBTI. This may require filing a tax return and paying taxes on the income or gain attributable to the leverage.
True, though at least you can make leveraged investments in Real Estate with an IRA. UBTI is not a reason to not make an investment; it is just something to be aware of and to factor into the final return. For those investors during a 401k, this issue does not exist.
Liquidity Common Objection – You would need to have enough additional funds in the IRA to take the RMD distribution every year starting at age 70.5. Which is not easily done if all of your IRA is invested in real property.
Wrong! Though Real Estate is not exactly liquid and a sale may take time you do not have to take cash as a distribution. You can simply take an ownership interest in the property as an in-kind distribution. As mentioned in the previous explanation this offers a tremendous opportunity for those with knowledgeable tax counsel.
No Step-Up In Basis Common Objection – If property owned (directly) is inherited, heirs receive a step-up in basis and could sell immediately paying no tax. If property is in an IRA, there is no step-up in basis.
Again, all IRA assets are treated the same whether discussing stocks or Real Estate.
Custodial Fees Common Objection – If you want to invest in Real Estate, you’ll have to find a custodian that specializes in holding real estate, and that will cost a lot of money.
All IRA’s are exposed to custodial fees whether those fees are embedded in a custodian’s investment offering or separately. Custodial fees vary dramatically from company to company and if using a 401k this is entirely a moot point since there is no requirement for a custodian.
ValuationÂ Common Objection – When you reach age 70.5, you are required to start taking Required Minimum Distributions (RMDs) from your IRA. If your retirement account owns Real Property, you would have to pay to get it appraised every year.
Wrong! Most custodians do not require appraisals unless the entire asset is taken as a distribution. This is a custodian-to-custodian policy not a federal requirement. In fact this subject poses a huge tax planning opportunity in that fractions of an asset taken as a distribution are not valued as a fraction of the whole, they receive a decreased valuation and therefore can save you a tremendous amount of tax with proper planning.
Higher Tax Rates Common Objection – When you sell real estate within an IRA, any gain distributed is taxed at ordinary income tax rates. This rate can be much higher than the capital gains rate you would pay on the sale of real estate outside of the IRA.
Wrong! Any gain on a sale will grow tax-deferred just as with any other investment. Any investment made with an IRA will be taxed at the same rate and at the same time; distribution.
No DepreciationÂ Common Objection – If you purchase a building with taxable (non-IRA) funds, you get to write-off depreciation. This is not the case with an IRA.
Again, this compares property owned directly to property owned by the plan. By the way, isnâ€™t this a clear example of one of Real Estateâ€™s advantage over Wall Streetâ€™s offerings?
If you want real estate assets in your IRA for diversification, you can avoid restrictions by purchasing shares in a Real Estate Investment Trust (REIT), Real Estate ETF, or Real Estate mutual fund. These are readily available through your current investment advisor or custodianâ€¦
These are simply Wall Streetâ€™s Real Estate offerings and they can be great investments for those wanting truly passive investments. They do not contain the restrictions because they simply do not offer the same benefits of owning the property directly.
In conclusion, we are talking apples and oranges. The previous arguments are made everyday and yet they really offer no true purpose. If one is to argue whether it is best to own Real Estate directly or via a retirement plan I can argue there are many advantages to owning the property directly. Yes, there may be some tax exposure on investments a plan makes in Real Estate though typically the taxes only apply to investments that take advantage of opportunities other assets do not offer. Whether an investor should use his or her retirement plan to buy Real Estate should be a decision based upon what investment offers the best return for the plan. Whether a plan owns stocks, bonds, precious metals or Real Estate the taxes will be the same and therefore the investments risk and return should be the factors that color the investment decision.
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