According to the Tax Code the only thing that you cannot invest your IRA money in is “collectibles”. Real estate is not considered a “prohibited investment”.
IRS Publication 590 (Individual Retirement Arrangements) tells us -
“If your traditional IRA invests in collectibles, the amount invested is considered distributed to you in the year invested. You may have to pay the 10% additional tax on early distributions, discussed later.
Collectibles. These include:
• Alcoholic beverages, and
• Certain other tangible personal property.
Exception. Your IRA can invest in one, one-half, one-quarter, or one-tenth ounce U.S. gold coins, or one-ounce silver coins minted by the Treasury Department. It can also invest in certain platinum coins and certain gold, silver, palladium, and platinum bullion.”
It goes on to discuss what you cannot do with your IRA (aka “prohibited transactions) -
“Generally, a prohibited transaction is any improper use of your traditional IRA account or annuity by you, your beneficiary, or any disqualified person.
Disqualified persons include your fiduciary and members of your family (spouse, ancestor, lineal descendant, and any spouse of a lineal descendant).
The following are examples of prohibited transactions with a traditional IRA.
• Borrowing money from it.
• Selling property to it.
• Receiving unreasonable compensation for managing it.
• Using it as security for a loan.
• Buying property for personal use (present or future) with IRA funds.”
In doing some brief research before answering the email I came across a good article on the subject by Kaye A. Thomas titled “Real Estate in Your IRA: Self Directed or Self-Destructed?” in The Tax Guide for Investors at FAIRMARK.COM. The following is from that article -
A prohibited transaction occurs when you interact with your IRA in certain ways. Here are some of the things you aren't allowed to do:
You can't sell property to your IRA, or buy property from your IRA.
You can't loan money to your IRA, or borrow money from your IRA.
You can't use the account, or any part of it, as security for a loan.
You can't receive goods or services from your IRA, or provide goods or services to your IRA.
You aren't allowed to do any of these things directly or indirectly. That means you can't avoid this rule by having your IRA deal with a company you own, or with a family member. And these are outright prohibitions: they aren't allowed even if you do everything in a fair and reasonable manner.
Looking at the list above, you can see how easy it would be to violate the rules if you hold real estate in your IRA. Even if your IRA purchases the property from an unrelated party, you'll have a prohibited transaction if you provide services to the IRA.
Suppose you have your IRA buy a broken-down property and fix it up so the IRA can sell it at a profit. That seems like a great way to add value, but if you personally do the remodeling work, or do it through a relative or a business you own, the IRS may say you've made a prohibited transaction because you're providing services to the IRA.
Suppose you have your IRA buy a rental property. Who is going to find tenants, collect rent and perform other management services? If you do this, or have a related person or business do it, here again the IRS may say you have a prohibited transaction.”
There are other reasons not to own investment real estate in your IRA. Because an IRA is treated as a tax-exempt trust, as I pointed out in an earlier post here at TWTP, like Vegas, “What Happens in an IRA Stays in the IRA”.
A real estate investment held inside an IRA will not allow you to take advantage of the potential tax benefits of –
(a) depreciation deductions,
(b) special lower capital gain rates on the gain from the sale of the property, and
(c) stepped-up basis to beneficiaries.
My bottom line to the client was – I do not recommend buying investment real estate property in an IRA.
Any comments or questions?