At the end of 2018, Americans had nearly $9 trillion in IRAs. Most of that money was (and continues to be) invested in “traditional” types of investments, such as stocks, bonds, mutual funds, ETFs, and annuities. But for those investors who wish to look elsewhere for returns, IRAs can provide a substantial amount of flexibility.
One investment option that is particularly popular when it comes to non-traditional IRA assets is direct-owned real estate. Direct-owned real estate refers to properties in which an owner (or a company controlled by that owner) has direct title to the property. But while the allure of non-traditional, non-stock-market-based investments like direct real estate can be an attractive proposition for many investors – especially in times of increased market volatility – such investments can also create unique planning challenges not normally associated with traditional investments.
Notably, though, direct-owned IRA real estate increases the likelihood of running afoul of the prohibited transaction rules. IRA owners, for instance, are prohibited from personally using their IRA-owned real estate, or performing even the smallest of repairs on the property themselves. Purchasing or leasing such properties personally is also off-limits, even when such arrangements are done as an “arms-length” transaction at a fair market value/rate.
But the list of potential challenges doesn’t stop there. Cashflow problems are also more prevalent when low-liquidity assets like direct-owned real estate are purchased within an IRA. The IRA, for instance, must have enough cash on hand to cover all of its “investment” expenses, including repairs and maintenance, taxes, and even the purchase of a property in the first place. And while an IRA can secure financing in the form of a non-recourse loan (i.e., a mortgage), such loans tend to limit the amount of capital that can be borrowed and can lead to Unrelated Debt Financed Income, which can complicate things even further by creating an income tax bill that must be paid by an investor’s IRA! All while other tax benefits normally associated with real estate, such as depreciation and the 20% pass-through deduction, are forgone (since the investment is owned in the tax-deferred IRA “shell”).
Real estate is also more difficult to value than assets that are frequently traded across an exchange or other platform. Which is unfortunate, because formal valuations of direct-owned IRA real estate are often required in the event an IRA owner takes a distribution, including (and especially when) there is a Roth conversion or a Required Minimum Distribution (RMD) obligation, adding an additional cost layer for otherwise-basic tax reporting.
Despite these risks, however, some investors still view these alternative/non-traditional IRA investments as their best avenue to grow their retirement savings… and do so with their IRAs if only because that’s where the available dollars are to invest in the first place. For such persons, a thorough understanding of these technical and tax compliance challenges is critical.