Can you use an IRA or Roth IRA to buy Rental Property?

November, 14 2022 by Carolyn Richardson, EA, MBA

With the stock market declines that have happened since the beginning of the year, you may see your retirement account balance shrinking by alarming amounts, and you may be wondering if there are better options for investing your retirement nest egg. Since real estate prices have skyrocketed in many parts of the country, real estate might seem like an attractive investment, but purchasing rental properties outright can be expensive. Not only do you have to come up with the closing costs, but when buying an investment property, most lenders will require a minimum down payment of 25% of the purchase cost. For most people, the only way to access that kind of cash is via their retirement accounts, which, until recently, were seeing record gains. You may have even done internet research and found some websites promoting investing in real estate using your IRA.

 

Is investing in real property, particularly rental property, a good idea for your retirement investments, especially your traditional IRA or Roth IRA?

For the right person, investing in a rental property using their traditional or Roth IRA can be an excellent way to invest their money and earn superior returns. Most IRAs, whether they are traditional or Roth IRAs, are invested in traditional assets which include stocks, mutual funds, bonds, etc. That being said, investing in a nontraditional asset with a retirement account is not something for the average investor. If you’ve done some internet research on the subject, you may have noticed that all of those websites discussing this option have the warning, “Consult with your tax professional or investment advisor.” Truer words were never written, because it’s quite easy for an unsophisticated investor to make mistakes in this type of investment, sometimes with dire consequences. And while there are many companies out there are willing to help you set up an IRA (for a fee) to invest in rental properties, once that account has been created, they don’t always offer much support in maintaining your IRA.
 

So, why is this so difficult?

Remember that an IRA account is a tax-deferred account and, as such, it has many rules that must be followed to keep it a tax-deferred account. And many of these rules are easy to run afoul of when investing in something like rental real estate. This type of IRA account is considered to be a self-directed IRA. And while every IRA account is self-directed in some way, many IRA accounts - particularly those that are invested in mutual funds or stocks - have a trustee who holds the assets of the IRA, monitors the account, trades investments if authorized by the owner, and provides the taxpayer with the value of the account on an annual basis. A self-directed IRA also requires a trustee, but you cannot be the trustee of your own IRA, so you have to find a trustee willing to accept rental real estate in your IRA. Most trustee firms, such as Fidelity or Vanguard, will not accept this kind of asset in your IRA. And with a self-directed IRA, it is the taxpayer’s responsibility to provide the trustee with the value of the account on an annual basis, not the other way around. For rental real estate, providing an updated account value may not be too difficult as real estate appraisals are easy to obtain for a fee. But the fee must be paid by the IRA, not by you as the IRA owner.

And then there’s the nitty-gritty of running the account. When an IRA is invested in traditional assets, you contribute money into the IRA account, the trustee purchases stocks or mutual funds for you, and that’s pretty much it. If you need to take money out of the IRA account, the trustee will sell the stocks or mutual funds and provide you with the cash in the form of a taxable distribution. Apart from the occasional portfolio rebalancing, you generally don’t have a whole lot of interaction with your IRA account. You do not hold the stocks or mutual funds physically in your hands.

But when it comes to placing a rental property inside an IRA account, can you do the same thing? Can you take a “hands off” approach? The first problem with investing in rental property in an IRA account is that the IRA cannot be liable for a loan. In other words, the IRA cannot take out a loan on a rental property, such as a mortgage. And as the owner of the account, you cannot take out a mortgage in your name on property owned by the IRA, or co-sign as guarantor a mortgage in the IRA’s name. This would be considered a prohibited transaction, and we will discuss the ramifications of prohibited transactions later in the blog.

Therefore, you generally must pay cash for any property that you want to purchase. “Okay,” you may be thinking, “I have enough cash in my IRA to purchase a property, so that’s not a problem. I have $400,000 in my account to buy a $400,000 property, right?” This leads to the second problem which may arise, which is maintaining the rental property in the IRA. What if a pipe bursts and a tenant’s apartment is flooding? Real estate requires maintenance and repairs to maintain its value. It also requires payment of annual expenses, such as hazard insurance and property taxes. Also, any rental income that is received must remain in the IRA account as well; you cannot deposit it into your own accounts. And while this income does stay in the account and can be used to pay for the ordinary expenses of owning a rental property, will it be enough? In addition to having to have the cash to purchase the property in the IRA account, you must also maintain enough cash balance to pay for the normal operating expenses of the rental property. All these expenses must be paid by the IRA and not by you directly. And the payments for these expenses must be made by the trustee of the IRA, not by you. This means you must direct the trustee to pay the expense. If you pay any rental property expenses from your own accounts or deposit the rent checks into your own non-IRA accounts, such as your checking or savings account, this would be considered a prohibited transaction.

An additional problem arises if the rental property requires a large capital expense for which you do not have enough cash in the IRA account. What do you do? For example, assume that you want to replace the roof on the rental property, and the cost of the new roof will be $20,000. However, you only have $5,000 in cash in the IRA account. Can you make a cash contribution to the IRA to make up for the shortfall? Yes, you can, providing you are eligible to make a contribution to the IRA, and you may even get a tax deduction for it if it’s a traditional IRA contribution. However, keep in mind that both traditional and Roth IRA contributions are limited by your income and whether you are covered by another retirement plan, such as an employer 401(k). And while you can make a nondeductible traditional IRA contribution, that creates its own problems. The amount of cash that you can contribute to the IRA is limited by law to $6,000 per year or $7,000 per year if you are age 50 or older (for 2022). Therefore, for a large capital expenditure on the rental property, you may not be able to contribute enough cash immediately to pay for a sizable expense.

In our example, making up the shortfall of $15,000 by contributing $15,000 in cash to your IRA account would result in an excess contribution. Excess contributions are subject to a 6% excise tax until they are withdrawn from the IRA account. But if you’ve already spent that money to replace the roof, you have no way to withdraw the money from the IRA account. Therefore, you could be on the hook for 6% of the excess contribution indefinitely until you build up enough cash within the IRA to make a cash distribution of the excess amount.

“No problem,” you’re thinking, “I’ll just buy the supplies through the IRA and do the work myself. That will be a lot cheaper, so I don’t need to have so much cash in the IRA.” Not so fast. When you own rental property in an IRA, you are not permitted to perform work on the property, not even to change a lightbulb or fix a leaky faucet. Again, this would be considered a prohibited transaction.
 

Taking required minimum distributions (RMDs)

But now, let us assume that you’re doing everything correctly, avoiding prohibited transaction pitfalls, and now your IRA with its rental property has significantly increased in value. You’re ready to retire and want to start taking distributions from your IRA accounts to fund your retirement. This is where it can get ugly with regard to the rental property in an IRA. Generally, when you hit 72 years of age, you must start taking required minimum distributions (RMDs) from the traditional IRA account (Roth IRAs do not have an RMD requirement), and the amount of those RMDs is based on the total fair market value of all your IRAs. It is impossible to distribute only a portion of the rental property and, while you might think you could quit claim a percentage of the property to yourself, that would result in you having an ownership interest in an IRA asset, and that would be – you guessed it - a prohibited transaction.

Therefore, you would have to have enough cash in your IRA account (or in another IRA account that is held in more liquid traditional investments) to pay your required minimum distributions. If the property has appreciated substantially and the IRA account value is correctly reported to your trustee, you may not have enough cash to pay your RMD, especially if your only IRA is the one holding the rental property. At that point, your only option is either to distribute the entire property (at fair market value) by retitling the property into your name, or to sell the property while it is still in the IRA so that you have the cash to pay your RMD. If you sell the property while it is still in the IRA, you can avoid paying tax on the sale even if you have a large gain. Remember, traditional and Roth IRAs are tax-deferred, and you pay no taxes on profits earned in the account. This is really the best option, tax-wise, once you hit your RMD age – not only have you managed to have your IRA grow if the real estate has appreciated, but you can sell it at a gain and owe no taxes on the sale. Just remember these transactions have to be done through the trustee.

If you distribute the property to yourself, the fair market value would be the distribution amount for that year. For example, if the property is now worth $600,000, you would receive a 1099-R from the trustee for $600,000. I think you can see that distributing the entire value of the property to yourself could result in a very large tax bill if it’s held in a traditional, tax-deferred IRA, as distributions are taxable in the year they are received. And since you are now holding property, not cash, paying that tax bill could be difficult if you don’t have other cash resources to pay the taxes. If you hold the property in a Roth IRA, however, the distribution would be non-taxable, as long as you have had the Roth IRA for at least five years. If you have held it in a traditional IRA, you could convert the IRA to a Roth IRA, but keep in mind that this type of conversion is taxable at the fair market value of the IRA at the time of the conversion. “But wait,” you say, “I paid $400,000 for the property – don’t I get to reduce the gain by the cost?” Not in an IRA. Keep in mind that if your IRA was a traditional IRA, you have no cost basis in the account unless you made nondeductible IRA contributions over the years (and those must be reported to the IRS when they occur). Even if you made nondeductible IRA contributions, creating a basis in the account, your basis for purposes of the distributions is limited to a portion of your nondeductible contributions.
 

What is a prohibited transaction?

We’ve mentioned “prohibited transactions” several times – so what is a prohibited transaction? Prohibited transactions are any event or action that would directly benefit a participant/owner of the retirement plan (the plan being your IRA). For the types of prohibited transactions listed below, the “disqualified person” would be you, the IRA owner:

• The sale or exchange, or leasing of, any property between the IRA and a disqualified person. In other words, you cannot sell IRA property to yourself or live in a property owned by your IRA.
• The lending of money or other extension of credit between the IRA and a disqualified person. This is why you cannot pay for property repairs for the IRA property out of your own accounts.
• Furnishing goods, services, or facilities between the IRA and a disqualified person. This is why the trustee of the IRA would have to pay the plumber to fix that leaky toilet and why you cannot repair it yourself.
• Transfer to, or use by, or for the benefit of, a disqualified person of the income or assets of an IRA. In other words, you cannot deposit the rental income into your own account; it must remain in the IRA.
• Any act by a disqualified person who deals with the income or assets of an IRA on his or her own account or their own interest.
• The disqualified person receiving consideration, such as wages, commissions, etc. from the IRA for furnishing goods or services that benefit the income or assets in the IRA. For example, if you are a realtor, you could not sell the IRA’s rental property and receive a commission for it (or even represent it for no commission, as that would be “furnishing goods or services” to the IRA).

What happens if you engage in a prohibited transaction in your IRA, even if you weren’t aware that it was not allowed? Well, in that case, the entire IRA ceases to be an IRA as of the first day of the year, and the IRA is deemed to have distributed all of its assets to the IRA owner at the current fair market value. In turn, the IRA owner must report the deemed distribution on their return. If it’s a traditional IRA, the deemed distribution is taxable to the owner. It doesn’t matter if the prohibited transaction happened on December 31; the distribution would be deemed to have taken place on January 1. Since we are a “pay as you go” tax system, underpayment of estimated taxes would occur, resulting in a penalty on top of a large tax bill.
 

If you still yearn to buy rental property inside your IRA, heed good advice and consult with a qualified tax professional and financial planner first.

Not all tax professionals or financial planners are well versed in self-directed IRAs, so you want to do your homework and find professionals that specialize in this type of IRA. Make sure you have a cash cushion in the IRA to pay for repairs and trustee fees. Finding an experienced and reliable trustee who can handle a rental property’s day-to-day running should be a top priority. Keep in mind that most trustees will not work with this type of investment, so you may need to search for a while. Become familiar with the rules around prohibited transactions so you can avoid them.

Whether you are about to dive into the world of self-directed IRAs and invest in rental real estate or have already taken the plunge, TaxAudit is here to help with our prepaid audit defense membership plan. Our tax professionals work as a team to provide comprehensive audit defense, whether you are facing a notice from the IRS or state income tax agency. Perhaps you already tried your luck at investing in rental real estate within your IRA and unintentionally made a prohibited transaction that caused a deemed distribution and hefty tax bill you cannot pay? Our Tax Debt Relief program offers personalized solutions when a taxpayer is facing serious tax debt.

The opportunity for growth can be very rewarding but investing in real estate inside an IRA isn’t for the faint of heart, so do your research and good luck!