People are pouring money into IRA real estate without understanding the traps and consequences
Buying real estate with funds in an individual retirement account (IRA) has been on the rise since the bottom of the housing bust in 2010. The prospect for 7% cash return and an extra 3% return as prices rebounded made IRA real estate a seemingly easy choice for many.
The problem is that many investors are finding out too late that real estate returns in an IRA are not as great as they appeared and there are several hidden traps that could cost them big later down the road.
Think Twice about Your IRA Real Estate Investment
The first problem with holding real estate in a tax-deferred account is that you won’t benefit from one of real estate’s biggest advantages. The tax break investors get on being able to write off property depreciation and other expenses can shield tens of thousands of your regular income from Uncle Sam. All of that goes away when you hold the property in a tax-deferred account because you can’t use any paper losses to offset your regular income.
All of the expenses for maintenance, insurance and taxes must come from the IRA funds or from your contributions. This means you’ll likely need to hold a cash cushion in your account to cover these expenses, cash that won’t be earning a return. All of this seriously eats into the actual return on an IRA real estate investment.
Even if retirement account real estate was able to provide higher returns, it’s one of the worst ways to waste your retirement investment. We uncovered how most people waste their 401k plan investments last week by not investing according to a holistic plan that accounts for all their wealth. The idea fits here with real estate as well. Most people already have a large exposure to real estate through their principal residence or other property. Loading up your IRA with real estate risks over-exposure to property prices and another housing crash.
But there’s even bigger traps with IRA real estate investments that most people don’t realize until it’s too late.
The IRS has a long list of disqualified persons that cannot use or provide services to the property. Besides yourself, this includes:
- Your spouse
- Any lineal ascendant (parents) or descendants (children or grandchildren)
- Anyone controlling the IRA real estate investment (investment custodian)
- Any business or entity in which you own 50% or more of the shares or control
None of these people can live in the property, use it as a vacation property or provide services like property management. Your IRA real estate is completely off-limits unless you want to face a hefty fine by the IRS. Since you’ll need a custodian to actively manage the property, you’re likely facing a management fee of at least 10% or more.
You’ll also miss out on another huge benefit of real estate investing, debt leverage. You won’t be able to get a traditional mortgage on your IRA real estate because most mortgages carry a recourse clause. This means that the lender can seize the property in the event you don’t pay the mortgage, something that’s prohibited in retirement accounts. The result, you might find yourself having to pay all cash for your IRA real estate investment.
Make it to retirement with your real estate IRA and you’ll face one of the biggest traps of all. After 70 1/2, you’ll need to pay for a valuation on the property to determine the Required Minimum Distribution (RMD). Your distributions, required or otherwise, must come from the IRA which means the property better be spinning off a lot of cash or you could come up short and will be forced to sell the property.
Better IRA Investment Options
A tax-deferred IRA is one of the best ways to protect your retirement assets from the government and you’ll have more IRA investment options compared to a traditional 401k plan. While real estate may be a great investment, it shouldn’t be held in a tax-advantaged retirement account.
Hold real estate in your taxed investment accounts so you can benefit from the write-off of depreciation and other expenses. For your IRA accounts, consider other investments that may be more appropriate. One of these may be precious metals and silver which are not typically offered with 401k plans. Precious metals offer many of the fundamental investment benefits of real estate including protection from inflation and the collapse of fiat currencies.
FAQs
Any real estate property you buy must be strictly for investment purposes; you and your family can't use it. Purchasing real estate within an IRA usually requires paying in cash, and the IRA must pay all ownership expenses. Holding real estate in your IRA can be tricky, with tax issues and red tape.
How to become a millionaire with an IRA? ›
5 Steps To Become A Roth IRA Millionaire
- 1) Open A Roth IRA Account.
- 2) Contribute Enough Money To Your Roth IRA Account.
- 3) Invest Your Roth IRA Contributions.
- 4) Take The Time To Become A Roth IRA Millionaire.
- 5) Don't Make The Mistake Of Raiding Your Roth IRA.
Start saving as early as possible, even if you can't contribute the maximum. Make your contributions early in the year or in monthly installments to get better compounding effects. As your income rises, consider converting the assets in a traditional individual retirement account (traditional IRA) to a Roth.
Can I partner with my self-directed IRA to buy real estate? ›
You don't have enough money in your IRA to purchase the property outright, and you don't want to get a non-recourse loan. Fortunately, you have options—including having your self-directed IRA partner with other investors to purchase the property. This is often called “purchasing an undivided interest” in the property.
Is it better to invest in real estate or an IRA? ›
If you're on a tight investment budget, you might be assessing whether investing in real estate or a Roth individual retirement account (IRA) is better. Real estate offers tax advantages and high potential returns, while Roth IRAs deliver tax-free growth and tax-free withdrawals.
Can I live in a house owned by my IRA? ›
Any property you purchase with your Self-Directed IRA must be for investment purposes only. You cannot live in or use the home for your personal benefit. Neither can certain family members. Additionally, you cannot sell the home to those family members.
How many people have $1 million in an IRA? ›
In fact, statistically, around 10% of retirees have $1 million or more in savings.
How many IRA millionaires are there? ›
Fidelity Investments, one of the largest administrators of workplace plans, said it had 422,000 401(k) millionaires at the end of 2023, a nearly 21 percent increase from the third quarter. The number of IRA millionaires hit a record 391,562 in the fourth quarter, about 40 percent higher than a year earlier.
How much do you need to put in your IRA to be a millionaire? ›
Still, the math behind becoming a Roth IRA millionaire still holds. Assuming an annual January contribution to your Roth IRA of $6,500 and an 8% average long-term investment return, you can expect to become an IRA millionaire in just under 34 years.
What is the best IRA strategy? ›
Filling your IRA with individual stocks and bonds is one option. Another is to compose your portfolio of mutual funds or exchange-traded funds (ETFs) for better diversification and, over the long term, better results.
If your income is too high, you won't be able to contribute to a Roth IRA directly, but you do have an option to get around the Roth IRA income limit: a backdoor Roth IRA. This involves putting money in a traditional IRA and then converting the account to a Roth IRA.
What is a good amount to have in an IRA? ›
Maxing out your IRA contributions is generally considered a good approach. So, assuming you are eligible to make the maximum contribution to your IRA, you can contribute $500/mo. if you're 49 years old or younger, or $583/mo. if you're 50 or older.
Can I cash out an IRA to buy a house? ›
You can, yes. But it must be your first home (or your first primary residence in at least two years), there is a $10,000 lifetime limit, and there may be penalties for withdrawing early. For Roth IRAs in particular, it also makes a difference whether you withdraw contribution funds or earnings.
Why not to use a Self-Directed IRA? ›
Complex Tax Rules – Investing through a self-directed IRA requires you to follow complex IRS tax rules that do not apply to other IRAs. Failure to follow these rules may result in unintended tax consequences such as extra taxes, financial penalties or even loss of the account's tax deferred status.
Can you sell property in a Self-Directed IRA? ›
IRS regulations don't allow transactions that are considered “self-dealing,” and they don't allow your self-directed IRA to buy property from or sell property to any disqualified person, including yourself, certain family members, and others.
Does an estate have to pay taxes on an IRA? ›
Your IRA is subject to estate tax when you die and your beneficiaries will have to pay income tax as the assets are distributed from the IRA. But there is also an offsetting deduction for the estate tax that the beneficiaries can take on their personal returns.
How do I avoid estate tax on my IRA? ›
How to Use a Roth IRA to Avoid Paying Estate Taxes
- You are not required to take minimum annual distributions from your Roth account. ...
- With a properly designated beneficiary, your Roth account will not be included as part of an estate in a probate process.
The IRS also requires that any real estate owned in your IRA be strictly for investment purposes only. That means you and your family members cannot use it for personal reasons – under any circ*mstances.
How do you handle an IRA in an estate? ›
Options for beneficiaries
- "Disclaim" the inherited retirement account. Available to all beneficiaries. ...
- Take a lump-sum distribution. Available to all beneficiaries. ...
- Transfer the funds into your own IRA. Available only to the surviving spouse. ...
- Open a stretch IRA. ...
- Distribute the assets within 10 years.
The first problem with holding real estate in a tax-deferred account is that you won’t benefit from one of real estate’s biggest advantages. The tax break investors get on being able to write off property depreciation and other expenses can shield tens of thousands of your regular income from Uncle Sam. All of that goes away when you hold the property in a tax-deferred account because you can’t use any paper losses to offset your regular income.