Most people don't understand the traps of buying real estate in an IRA

Most people don't understand the traps of buying real estate in an IRA

July 27, 2023

Most people don't understand the traps of buying real estate in an IRA. Real estate and IRAs have many benefits, but combining the two can be a costly move. Let's dive into 8 reasons why buying real estate in an IRA can bring more hassle than it's worth...

1. You lose the tax benefit: You place a tax-advantaged asset in a tax-advantaged account. Real estate is already a tax-efficient asset. With a real estate business, you get to deduct expenses like insurance, maintenance, repairs, and fees. And the biggest tax benefit of depreciation, which you don't get to take advantage of in an IRA. If the property has a negative cash flow, you don't get to claim the loss either! Placing a tax-efficient asset in a tax-advantaged account is bad financial and tax planning.

2. RMD rules still apply: At RMD age (in your 70s), you must start taking mandatory distributions, which are taxed at ordinary income. If there is no liquidity to distribute from your IRA, you could become a forced seller. Rule #1: NEVER become a forced seller of assets.

3. Could create concentration risk: If you are using an IRA or retirement assets to purchase a piece of property, you may not have the financial means outside of this account. This could indicate the property is a large percentage of your investable assets. This can put a heavy tilt of your investment portfolio into one asset, giving you a little flexibility to diversify.

4. Decreases cash flow flexibility: Real estate is generally used to create alternative sources of income and wealth, hopefully before the traditional retirement age. With real estate in an IRA, this cash flow can’t be accessed before age 59 ½ without a penalty.

5. Turns liquidity into illiquidity: Retirement assets invested in the stock market are considered liquid investments. They can be turned into cash quickly. This is both a good and bad thing from a behavioral investing standpoint. However, buying a large Illuqid asset like real estate can put your balance sheet at illiquidity risk. You want to retain some liquidity with your total investment portfolio.

6. Strict rules can disqualify the IRA: If you don't follow some of the strict rules and the IRS finds out, it can disqualify your IRA and make all the funds taxable.

Here's a breakdown of the rules:

  • Self-dealing: Per the IRS you can't do business with yourself. This means you, certain family members, or disqualified persons cannot live or vacation in an investment property owned by your IRA.
  • Sweat equity: You, certain family members, or disqualified persons cannot work on the property, renovate, or do any maintenance. This is considered an indirect money benefit.
  • Mixing IRA and personal money: You must pay all the property expenses with IRA assets. So there must be enough funds to make these payments. You cannot pay them with personal money. 

7. Reduced leverage benefits: A big benefit to real estate investing is leverage. You can control a large asset with little money down, boosting returns and cash flow. When real estate is purchased in an IRA, you don't have the ability to get a traditional mortgage. You may have to pay all cash, which can reduce returns. However, you can possibly use a nonrecourse loan, which typically has higher rates and require a much larger down payment.

8. Must use a self-directed IRA: This is different from a regular IRA account that can be set up at a brokerage firm. With a self-directed IRA, you must find a custodian that offers these accounts. You have the responsibility of the account to abide by the IRS rules.

Before buying real estate in an IRA, do your homework. Real estate is a great way to build wealth, but the benefits decrease, and the hassle increases when purchased in an IRA.