Rental Property in an IRA?
February 22, 2012The second week of April is Spring Break for our kids so this year we planned a family vacation to Amelia Island, Florida. We’ve never been there before so after perusing several possible forms of accommodations, we settled on a condominium close to the beach. As expected, the owners of the rental property requested one half of the rent up front and then the remainder at the time of occupancy. What made this particular request a little different was who, or in this case what, we made the check payable to. Usually you make a check out to a person or to a rental management agency but in this instance we made our check payable to the property owner’s individual retirement account (IRA). Huh?
I’ve known for a while that it was possible to own rental property in a retirement account but I never met someone who had actually done it and to be honest with you, I’m not quite sure why they would want to. I looked on the Internet for reasons why someone would want to own rental property in an IRA and I found a lot of information. Like any financial decision, I suppose there are pros and cons. For starters, rental property, like other property, is considered an appreciating asset (though not necessarily in the last five years) and it makes a nice complement to stocks, bonds, and other types of assets but there are other ways to hold real estate in an IRA, such as a real estate investment trust (REIT). In fact, a REIT overcomes some of the major challenges faced when you own physical real estate, namely geographic and liquidity risk.
I suppose another reason to have rental property in a traditional IRA is to defer the taxes associated with the income or the gains but again I’m not sure I completely understand this logic since most rental property owners offset the income with operating costs and depreciation (which may still be available if the property is purchased with a mortgage—check with a tax professional on this). In fact, there is a disadvantage to having real estate in a traditional IRA in that the value of the asset will be taxed as ordinary income if and when it is distributed from the account. I guess it doesn’t make a difference if you are just buying and selling property along the way but eventually the gains will be taxed and at ordinary rates instead of capital gains rates (which are generally preferred when the property is held over one year prior to sale).
Maybe the owners are planning to relocate to Florida after they retire and using their retirement account to purchase the property allows them to pay cash for it now, when the prices are reasonable, without the need to borrow (which, by the way, is more expensive when financing investment property). Then, when they do retire, they’ll sell their current home, exclude up to $500,000 in capital gains (if married filing jointly) and settle in to their new home which has been paid for with money they might have used anyway to purchase it. Now that sounds promising but remember that there are restrictions for personal use of real estate owned in traditional IRAs so moving in may also create the unintended consequence of a large taxable distribution. Even if you don’t move in, required distributions must begin when the account owner reaches age 70 ½ so eventually this property will need to be sold, either to satisfy a required distribution or when it is inherited by heirs.
So with all of that being said, when does it make sense to purchase rental property in an IRA? Well, one thing you may want to consider is the option of purchasing rental property in a Roth IRA. You see, with a Roth IRA, you don’t run into those pesky income tax or required distribution issues. Even if the kids inherit the property, as long as the account has been held for at least five years, there are no income tax consequences. So if you find a sweet deal and you like the idea of paying cash for your future retirement home then buying rental property with your Roth IRA might just be your ticket to paradise.
A word of caution: before you run out and use your retirement funds to purchase rental property, remember that the home you live in right now is also an investment so be careful not to concentrate too much of your assets in real estate. As we learned in 2008, even real estate can lose value. One way to avoid over-concentration is to use the income from rent to purchase other non-real estate investments. Also, because retirement accounts that hold physical real estate incur additional custodial charges and because physical property is subject to geographic risk, if you are simply looking for an investment in real estate to diversify your portfolio, you may want to check out some other options like REITs.
I’ve given you just some high-level things to consider regarding owning rental property in a retirement account. There are many other things to consider, including insurance, maintenance, property taxes and vacancy, just to name a few. It’s best to decide first if owning rental property is right for you in general BEFORE you consider whether or not to hold it in an IRA.