Real Estate in an IRA? Think Twice

August 11, 2023

Occasionally, I come across folks who are interested in buying real estate in an IRA. On the surface, it might seem like an option to explore. But when you dig a little deeper, there isn't much much benefit to putting real estate in an IRA. I'm going to break down 8 reasons why you should think twice before buying real estate in your IRA.

1. Loss of tax benefits

Placing a tax-advantaged asset like real estate into an already tax-advantaged account (IRA) could lead to a loss of tax benefits. With a real estate business, you receive tax deductions, including insurance, maintenance, repairs, fees, and depreciation. Speaking of depreciation, this is one of the most significant tax advantages to real estate investing. You can’t take advantage of these deductions when you own real estate in your IRA. If the property has negative cash flow, you cannot benefit from the loss. Placing a tax-efficient asset into a tax-advantaged account isn't good financial and tax planning.

2. RMD rules apply

Reaching the mandatory distribution age (usually in your 70s) subjects you to Required Minimum Distributions (RMDs), which are taxed as ordinary income. If you have no liquidity in your IRA (because your money is tied up in an illiquid asset) to distribute to satisfy the RMD, you could be forced into selling. My rule #1 for investors?... Never become a forced seller.

3. Increased concentration risk

If you are considering using IRA funds to buy real estate, it's possible you don't have the financial resources to purchase such a large asset yet. Using retirement funds, such as those within your IRA, to buy a single property could put a lot of financial weight on one asset. A disproportionate investment in a single property could create an overly concentrated and illiquid investment portfolio, limiting your flexibility.

4. Limits cash flow flexibility

Typically, real estate investments are designed to generate alternative income and wealth, hopefully before the traditional retirement age. However, funds in an IRA generally can't be accessed penalty-free before age 59½. Meaning you likely cannot access the cash flow without penalty! This substantially reduces the benefit and flexibility of cash flow from real estate.

5. Turns liquidity into illiquidity

Retirement assets invested in the stock market are considered liquid on your balance sheet, allowing for quick conversion to cash. In contrast, physical real estate is illiquid, which may create a risk to your financial liquidity. Maintaining a balance between liquid and illiquid assets is essential for a well-built investment portfolio.

6. Strict rules and disqualification risks

Failing to adhere to the strict rules associated with IRA investments can result in the disqualification of the entire IRA, subjecting all funds to taxation. Here are a few rules to be aware of:

Self-dealing: The IRS says you can't do business with yourself. In other words, the IRS prohibits certain interactions between you, your family members, and disqualified parties with an investment property your IRA owns. Living or vacationing in such property is considered self-dealing and is not permitted.

Sweat equity: You, certain family members, or disqualified individuals cannot work or perform tasks like renovations, maintenance, and repairs. This is considered an indirect financial benefit and is disallowed.

Mixing IRA and personal funds: All expenses related to the property purchased within an IRA must be paid using IRA assets. It's important to have sufficient funds within the IRA to cover these expenses, as using personal funds is not allowed.

7. Reduced leverage benefits

One of the significant advantages of real estate investment is leverage. This essentially allows you to control substantial assets with a smaller amount of your capital. However, when real estate is acquired through an IRA, the conventional mortgage option becomes unavailable. This means you may have to pay for the asset with all cash, which reduces leverage and returns. Although non-recourse loans are possible, they often come with higher interest rates and larger down payments, reducing potential returns.

8. Self-directed IRA is required

Investing in real estate through an IRA requires a self-directed IRA, which differs from a regular IRA offered by brokerage firms. You are responsible for finding a custodian that provides self-directed IRA services. Self-directed also means you are responsible for ensuring compliance with IRS regulations.

Investing in real estate in an IRA might seem appealing, but it's crucial to understand the potential drawbacks and risks associated with this strategy. Part of a good investing strategy is combining simplicity with an overall wealth-building strategy. Buying real estate in an IRA can complicate your strategy. Not to mention create unnecessary taxes if not done right, which is the last thing you want with your IRA. If you are ever pitched buying real estate with your IRA, consult your financial tax professional to make an informed decision that aligns with your long-term financial goals.

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