Disadvantages of Real Estate in an IRA

by Craig Woodman

Individual retirement arrangements (IRA) were created to allow smaller company owners and employees to have their own tax-advantaged retirement accounts. These accounts are generally invested in bank accounts or certificates of deposit, or even bond and stock mutual funds. Since IRAs are a long term investment, real estate may be a suitable investment for these accounts. While real estate in an IRA has its advantages, it also has significant downfalls that warrant careful consideration.

Difficult Set-Up

Finding an IRA custodian who will work with a self-directed IRA to allow the owner to invest in real estate can be difficult. Once you find that trustee, you must arrange a transfer of your existing IRA funds to the new trustee. You will then sign a direction letter to the trustee, which allows him to purchase particular real estate for you with the IRA funds. A person generally should have professional help from a lawyer and an accountant when setting up these accounts.

Unrelated Business Income Tax

Unrelated business income tax is a tax imposed on debt-financed income held inside of retirement plans. If you purchase a property for $200,000 within your IRA account, and put $100,000 down, financing the remainder, you cannot shelter all of the income from the IRA from taxes. Since you have invested 50 percent of your own funds into the property, you can only shelter 50 percent of the income. The other 50 percent is taxed at your normal income tax rate. IRS form 990-T reports the taxable and non-taxable portions.

Trustee Confidence

You must have confidence in your trustee when engaging in this type of investment. In many states, it is unclear who regulates the trustees, making regulatory oversight difficult. You need to know that your trustee is handling the money correctly, and is completing all required paperwork for your investment. If not, your IRA could be disallowed as a tax-advantaged investment, and you could owe income taxes on your contributions.

No Sweat Equity

Properties purchased in a self-directed IRA must be managed by the trustee, or an outside management company that is hired by the trustee to handle the affairs of the property. This arrangement also applies to repairs on the property. Performing your own maintenance or upgrades on the property is viewed as an additional investment in the property, which could push you over the yearly limits for IRA contributions.

Higher Fees

Self-directed real estate IRA accounts are much more work than a conventional IRA. Therefore, you will pay higher fees for the privilege of investing in real estate with retirement programs. In addition, you will probably face higher fees for having the trustee or another company handle the day-to-day management of the property.