Monday, June 14, 2004

Finance

Is a real estate individual retirement account right for you?

By William Harris

For tax-deferred retirement accounts, one asset class is being overlooked: real estate or real estate held within your individual retirement account or other qualified retirement plan.

Few people or institutions talk about owning real estate within a self-directed IRA or real estate IRA. However, it may be the only way some investors can participate in this real estate boom. Many Americans have the majority of their wealth tied up in retirement plans. Tapping into these accounts may offer diversification and/or an alternative to the traditional capital markets.

An IRA is a trust or custodial account set up in the United States for the exclusive benefit of you or your beneficiaries. The account is created by a written document. The trustee or custodian must be a bank, a federally insured credit union, a savings and loan association or an entity approved by the IRA to act as trustee or custodian.

There are restrictions on what can be invested in an IRA. The law does not permit IRA funds to be invested in collectibles such as artwork, stamps, rugs and antiques. Nor does the law permit IRA funds to be invested in life insurance contracts. But the Internal Revenue Service allows real estate.

But this strategy is cumbersome. IRA trustees may impose restrictions on investments. Because of the administrative burdens associated with real estate transactions, many trustees do not permit IRA owners to invest these funds in real estate. While the law does not prohibit it, trustees are not required to offer real estate as an option.

A self-directed IRA is similar to any other IRA. You find a bank or trustee willing to be the custodian. Few institutions participate in real estate IRA custodianships. But when you find one, you self-direct your investments. You buy and sell real estate, and you defer taxes.

Raw and undeveloped land, single-family, multidwelling units including apartment buildings, and commercial properties all qualify. Any real estate can be bought and sold within the real estate IRA. However, you or your relatives cannot live, work or participate in the property. The custodian will require a qualified third-party manager to manage any property. Also, any expenses must be paid out of the IRA trust account.

When you are ready to transact, notify your custodian. The property must be purchased with assets within the IRA. You cannot use personal funds and be reimbursed.

If you pursue this route, all rent payments must stay within the IRA. Those payments can be used for future purchases, offsetting expenses and covering debt. All transactions must flow through the IRA account. Any escrow accounts must be opened by or in the name of the IRA account. It cannot be in the name of the beneficial owner.

You can use leverage, but it isn't easy. IRS guidelines are sketchy. You must find a lender who is willing to participate in a non-recourse loan. In this context, it means the IRA, as a separate entity, is the borrower. If the loan goes into default, the bank can go after only that property. It can't touch the other assets in the IRA. In addition, the IRA custodian or trustee must permit leverage. Most custodians will require property to be purchased outright through the IRA with no debt financing.

You can buy a future retirement home, but there's a caveat. The minute you use the property for your personal use, the tax-deferred status is disqualified. For example, let's say you buy a condo outright from capital in your IRA for $100,000, retire 15 years later and the condo is worth $300,000. If you move in, you trigger a $300,000 distribution from a retirement account.

So you can purchase real estate via your IRA or qualified retirement plan. A significant IRA balance, one that is greater than the price of the property to be acquired, will make this strategy more attractive. The red tape and record keeping can be overwhelming. Make sure your custodian has administered other real estate IRAs.

This strategy is different than traditional real estate transactions. However, it may add diversification and allow you to tap locked capital and participate in the current real estate boom.

For more information on this topic and to make sure it is right for your situation, check with your financial professional. Also, visit www.IRS.gov.

William Harris is owner and chief investment strategist of Duxbury-based WH Cornerstone Investments, and the creator of the Future Focus Quest, a wealth management system for women.