Although the majority of IRA account owners are invested in CDs, stocks, bonds, mutual funds and annuities, don’t assume that these represent your only choices. If properly handled, non-traditional retirement investments, or NTIs, such as limited partnerships, private placements, trust deeds and notes, and real estate can be legally held in IRAs and certain retirement accounts.
Real estate is the most popular non-traditional investment for IRAs, although many of the investment advantages of owning real estate, such as depreciation and favorable tax treatment of profits, are not available or applicable when real estate is held in an IRA. Also, it is possible to get real estate diversification simply by purchasing publicly traded real estate investment trusts, or the mutual or exchange traded funds that invest in them. Some of the larger and well known funds include the Vanguard Real Estate Index Fund (VGSIX), the Fidelity Real Estate Investment Fund (FRESX) and Cohen & Steers Realty Shares (CSRSX.) Some investors, however, are not just concerned with diversification, but are interested in holding a particular property or multiple properties in their IRA. Here are the steps to take.
First, you will need to find a custodian who is willing to hold real estate investments in an IRA. Most banks and brokerage firms shy away from custody of real estate in IRAs because of valuation issues, as well as other administrative problems. PENSCO Trust Company, chartered in New Hampshire, is one of the largest IRA custodians that hold NTIs; there are a number of other as well, and excellent resources on the web to give you a broad overview of your choices.
You will need to establish an IRA with your new custodian and transfer funds into it from an existing IRA. During this process your custodian will be a valuable resource; they can guide you through the administrative requirements for holding the type of real estate you are planning to buy, although they certainly can't give you advice on a particular piece of property.
The simplest scenario is one in which you purchase real estate in your IRA from an unrelated party, for all cash. You cannot use non IRA funds for closing costs or any transaction related expense. All costs must be paid from the IRA, and all income must stay within the IRA. Future property expenses must also be paid from IRA funds, so be sure you have an adequate reserve put aside.
It can get a little more complicated if you plan to borrow or leverage. Loans are permitted on property in an IRA, but subject to strict rules. The loan must be a non-recourse loan; that is, the lender cannot hold or look to your personal assets as collateral if there is a default or deficiency on the property. For understandable reasons, lenders are often unwilling to make this type of loan.
There are also some complex rules that can get investors tripped up, relating to prohibited transactions and disqualified people. Prohibited transactions would include, among other things, selling a piece of property you already own to the IRA, or buying real estate and then permitting a disqualified person to use it. You also may not purchase real estate for your IRA from a disqualified person. Disqualified persons include you (the IRA owner), your spouse, parents or grandparents, children or grandchildren, and their spouses as well. Failure to strictly abide by the rules can result in not only the real estate assets, but the entire IRA, deemed “distributed” by the IRS, with tax due on all assets. If you are under 59 ½ this can result in penalties as well.
Investing in real estate and other NTIs in an IRA has been worthwhile and lucrative at the right times for the right investors. Just be sure to do your due diligence, not only in property selection, but by finding a knowledgeable custodian who knows the rules, and consulting your tax and legal advisors as well.
Steven Weber, Registered investment advisor, and Gigi Harris, Dir., Client Communications, are members of the Bedminster Group, a fee-only advisor providing investment and financial counsel to clients in the Low Country since 1997.