Can you remember back to those heady days when real estate was the hot investment? It really wasn’t that long ago- just a few years. At the time, you’ll undoubtedly recall that the only thing people wanted to sink their money into was property, whether it was a home, condo, apartment building, you name it, people wanted it. Who cared if you never planned to live in it? The goal was to “flip” it a couple months later and rake in a huge profit. Speculation was especially rampant in southern California, Florida, Colorado, Nevada. 

Short on cash? No problemo! Lenders were tripping over themselves to offer mortgages with little--or even no-money down.Want to avoid income tax on the fat profit you were (practically) guaranteed to make? Just have your IRA buy the property!Newspapers, magazines, the Internet, and television carried exciting ads about companies that would help you own real estate inside your IRA.

During this time I wrote about the complexities involved and warned of the consequences of making a mistake. Now that the real estate boom has gone bust-o with gust-o, reality is sinking in for folks who used assets in their IRAs to cash in.

More Complicated & More Costly

Owning real estate in your IRA is perfectly legal. However, you need to find an IRA custodian that is willing and capable of accommodating this. To begin with, you have to have a so-called “self-directed” IRA.  Expect the fees to be significantly higher than that of a brokerage firm or mutual fund. The reason is simple: The custodian of an IRA that owns real estate has more duties to perform.

These duties include paying property taxes, cashing rent checks and paying for repairs and maintenance. What’s that? You thought you’d take care of these things yourself?  FAGEDABOUTIT!

Separate “Personal” and “IRA”

The key thing to understand is that you must never commingle your personal assets and your IRA investments. Dean Barber, president of his own registered investment advisory firm in Lenexa, Kan, says, “All of the money to maintain the property and pay taxes has to come from within the IRA.”

So if the air conditioner goes out and you write a check from your personal account to get it fixed, the IRS says you’ve just made a “contribution” to your IRA, according to Barber. You need to take this amount into consideration when you make your annual IRA contribution so that you don’t go over the legal limit. (See below.)

Cash Flow Crunch

Natalie Choate, a retirement plan rules expert, points out another way you could inadvertently make a serious mistake.

Let’s say your tenant moves out and the rental property owned by your IRA sits vacant for a month or so. As the house sits empty the property tax bill arrives and you don't have enough cash in your IRA to cover it. 

Faced with the choice of: 1) ignoring the tax collector and losing the property, or 2) adding money to your IRA to cover the bill, most people would opt for the latter. But by choosing option No.2 means you made a “contribution” to your IRA.

If you already contributed the maximum $5,0001 for this year, you have now exceeded this amount and are subject to a 6% excise tax. According to Choate, to avoid the penalty you have to withdraw the excess amount by April 15 the following year. 

The lesson in both of the above examples? Your IRA needs its own checking account to handle inflows and outflows of cash. The custodian--not you--would then cut a check for repairs, taxes, etc. Rent checks would be made out to the IRA custodians.

Vanishing Tax Benefits

Your IRA might even have to file a tax return! 

In most cases, income earned by the investments in your IRA is either tax-deferred (traditional IRA) or tax-free (Roth IRA). However, if an investment is financed by debt- such as a mortgage- a portion of your IRA income becomes taxable in the current year. This falls under the category of “unrelated business tax income,” or UBTI. 

As explained by the Comptroller of Harvard University, one form of UBTI is “debt-financed income, which is usually in the form of rent, interest, or royalties arising from financed property.”  In other words, if the real estate owned by your IRA has a mortgage, the rental income your IRA collects is UBTI.  Instead of being tax-deferred or tax-free, it’s taxable to your IRA in the year it’s earned.

Buyer Beware

The sharp decline in home prices can turn IRA-owned real estate from a headache into a nightmare.

Imagine that your traditional IRA bought a piece of property for $230,000 two years ago in a “hot” new sub-division east of L.A.  By liquidating other investments, your IRA put down $10,000 and took out a mortgage for $220,000. 

Today, there are a dozen homes identical to yours sitting vacant in the same neighborhood.  Thanks to the bursting of the bubble, potential buyers are few and far between and the house is now worth less than the mortgage. 

You finally get an offer of $190,000 and want to accept it just to get out from under this weight. But your IRA is still short $30,000 to pay off what you owe on the mortgage and there’s no other asset in your IRA that you can sell to generate the cash.

“You have to come up with the money somewhere to pay the bank,” says Barber. “But if you pay it with your own personal funds, this disqualifies your IRA.” Now the entire amount left in your IRA is immediately taxable.

Prohibited Transactions

The Tax Code(2) lays out strict rules on what types of activities and investments are not acceptable when it comes to your IRA. 

For instance, you cannot personally benefit from an investment your IRA holds. Thus, the real estate your IRA owns cannot be for your personal use, or for a family member.

You cannot even benefit indirectly. Choate uses the example of renting the apartment owned by your IRA to your mother-in-law (so she doesn’t move in with you). 

In addition, you can’t “sell” your brother’s IRA your vacation condo in Florida in exchange for his IRA buying your cabin in the mountains. All transactions must be “arms length,” i.e. with a disinterested third party.

The list of “prohibited transactions” is long and complicated and it’s easy to make a mistake. 

The Bottom Line

As Barber points out, real estate offers a number of tax advantages when it’s owned outside an IRA, such as “depreciation, write-offs, and long-term capital gains when you sell.” You lose these if the property is held inside an IRA.

To sum it up, think long and hard before having your IRA directly own real property. There are other ways to invest your IRA in real estate- mutual funds, real estate investment trusts that do not involve specialized custodians or subject you to the potential pitfalls mentioned here. The also offer the benefit of greater diversification.

If you decide that this is still the path you want to take, make sure you’re working with knowlegable experts who can keep you on the safe side of the law. And make sure your IRA sets aside a stash of cash for unexpected expenses it might have to pay.

1.Individuals age 50 and older may contribute an additional “catch-up” contribution of $1,000.

2. IRC Section 408(e)(2).