This is Not a Good Deal: Buying Property with Real Estate IRAs

Hey everyone, welcome to We're Talking Money. Hopefully you watched our show, Should You Buy Real Estate in Your IRA. Now, that show had a lot of responses, had a lot of views, and that tells me that truly a lot of people want to know: does it make sense to put real estate in your self-directed IRA? Now, owning real estate in a self-directed IRA offers several advantages, but as you know, nothing is perfect.

Welcome to and We're Talking Money. I'm Phil Clark, wealth advisor and founder of OmniStar Financial Group, and today it is all about real estate IRAs, AKA self-directed IRAs. We did a show just a few months ago on how to establish a self-directed IRA for the purpose of owning real estate. We also covered prohibited transactions; they must be avoided. But that video, while it was good to help you understand how to set up the IRA and transactions that you must avoid, it did not focus on why self-directed IRAs may not be such a good idea.

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First, let me do a little refresher on why it seems like a great idea to use a self-directed IRA for purchasing real estate. Well, first, it allows you to diversify your retirement portfolio. Real estate can be a great investment. Generally appreciates, and when rented, it provides good cash flow.

Next is the potential tax benefits. Now, we said in the last show that any rental income, capital gains or appreciation that's generated by the property, all of those grow tax-free or tax deferred. Of course, you pay tax on it when those dollars start coming out of the IRA, but during the growth phase it's tax deferred, and that is a good thing. You can see from the chart both offer great benefits, but which one is best? I think as we get into the disadvantages, you'll start to recognize which one is best for you.

So the disadvantages start with complexity. So it's not simple. Managing your real estate investment in a self-directed IRA can be quite complicated. IRS rules must be followed. Remember, if you violate any of those prohibited transactions, your IRA could be disallowed, and that would make it taxable immediately.

Second, you need to know something about real estate. Now, this might sound simple, and this might sound like a "well, of course" kind of thing, but buying real estate, whether it's land or a structure, there is no guarantee that it will make money. There's no guarantee that you know what you're doing. Making mistakes can be very costly, and they can prevent you from reaching your retirement goal. And after all, that's exactly what you're trying to achieve when you're doing anything in a retirement account like an IRA.

The next disadvantage, it's liquidity constraints. While real estates can provide steady income through rents, it may be challenging to access funds quickly if you need them in an emergency. In fact, several steps must be taken, and of course, you're going to need a buyer for the property.

Next, self-directed IRA real estate investments likely give up a number of tax benefits that could be obtained if the real estate is owned outright. Why? Well, real estate as an asset has two major tax advantages. First is profit from real estate will always be considered capital gain, as opposed to ordinary income. Big difference. And that means if it's capital gain, you're going to enjoy a much lower tax rate. Secondly is something called depreciation. Depreciation of the property can be used as somewhat of a tax deduction. That's the easiest way to think about it.

When real estate is in your self-directed IRA, all profit, while it is deferred, it's ultimately going to be counted as ordinary income, and depreciation, it's never considered. On the other hand, most rental properties, when they're owned outright, they generate income with little to no income tax. You heard me right, little to no income tax. And that is the efficiency that can be lost when you choose to own real estate in a self-directed IRA. I'm not saying they're all bad. I am saying there's quite a few disadvantages that I don't think are talked about enough.

Potential disadvantage is RMDs. That's the old required minimum distributions. Now, you might not be at an age where those are required, but when you reach age 72, or 73 if you turned 72 after December 31 of 2022. Just as you might be thinking, that's a new law that took place last year, and so age 73 is likely the age that will affect you. And so those distributions, they are mandatory. And so because they're mandatory, that has to be thought about when it comes to owning real estate in your self-directed IRA.

Now, if the real estate IRA holds any type of real estate investment, or any illiquid asset for that matter, you need to know both the value of the account and the liquid cash in order to plan for those required minimum distributions. That means real estate must be appraised. Then your distributions need to be taken in cash, and depending on when you purchase the real estate, it's possible that some cash has accumulated from things like rental income. And let's hope so, because you can't exactly distribute, say, the front porch of your IRA rental property to yourself while leaving the rest of the property in the IRA. It doesn't quite work that way.

If you don't have the cash in your self-directed IRA, or in another IRA from which you could pull the required distribution, there is another option, and it's called in-kind distributions. An in-kind distribution allows an account holder to make a distribution from a real estate IRA by transferring a percentage of the property's ownership. In effect, the property is portioned, and it becomes distributable.

Here's how it works. So you, the account holder, would determine the amount of your RMD, and this can be done somewhat in a manual way by using an IRS RMD worksheet, or you could ask your CPA or your financial advisor. Once you know the amount of your RMD, you can start this in-kind process, and the first step is to have the property appraised. Now, keep in mind, this is not a market value assessment that your realtor performs. We're talking about a bona fide appraisal, and it is required by law. This is how you're going to know what percentage of the property needs to be distributed.

And finally, the last step is drafting a quitclaim deed that transfers the requisite percentage of the property from the real estate IRA, or an IRA LLC, to you, the account holder. Now, this means that the ownership of the property will now be divided between you personally and the IRA. From this point, all property expenses and income will be split according to the new percentage ownership. Sound complicated, with a lot of extra work? Sure does to me. Moving parts that are really not necessary.

Owning real estate in a self-directed IRA, it can be, and I am the first to admit it, can be a powerful tool for diversifying your retirement portfolio and taking advantage of some tax benefits. However, it is also clear that the complexity and liquidity constraints associated with self-directed IRAs, they should be very carefully considered before you take the plunge.

Now, I hope this video has inspired you to learn more about real estate investing and whether it makes sense to use a self-directed IRA or to make an outright purchase. If you are not sure, contact our firm. We can give you a second opinion, and we'd love to help. If you found this video helpful, please give it a thumbs up and subscribe to our channel so you never miss another great episode. I'll see you next time on We're Talking Money.

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