December 11, 2015 in IRA

Why real estate investing in a self-directed IRA makes no sense

real estate in an IRA

The stock market’s recent volatility has created concern among investors about relying too much on equities to fund their retirement years.

Some have turned to real estate investing directly in their IRAs to avoid the risk of stocks. But that strategy itself is risky, and many investment and tax experts recommend steering clear of it.

“Caveat emptor,” or, let the buyer beware, says Karim Ahamed, senior investment adviser for wealth management firm HPM Partners in Chicago.

He and many others cite multiple reasons why buyers should beware. These include tax issues, the perils of investing in individual real estate properties and the pitfalls of dealing with these properties in an IRA.

“Unless someone is holding your hand and you know what you’re doing, the chances of getting tripped up are good,” Ahamed says. “So you’re better off not getting in trouble. You can invest in real estate through a (mutual) fund or REIT, where you get the benefits of the structure without the risk coming into play.” Those benefits include diversity in geography and types of properties.

Read on to learn the detailed case against real estate investing in a self-directed IRA.



Purchasing individual real estate properties isn’t for the novice investor. Many factors go into the valuation of property: the neighborhood it’s in, recent sale prices for similar properties, the strength of the economy. And the factors determining the value of a residential property are often different from those determining the value of a commercial property.

When it comes to research, you’re pretty much on your own. “If you’re buying a mutual fund or a stock, you will find some analytical resources on whether it’s a good idea or not,” says Christine Benz, director of personal finance at Morningstar, a Chicago-based financial research firm. “It’s not as illuminated a playing field for real estate.”

Real estate is an illiquid asset: You can’t just sell it with the click of a computer like you can a REIT, stock or mutual fund. The price of a property can just as easily fall as it can rise, and often for reasons that are unpredictable, such as a shock to the economy or financial system. Plenty of investors were caught unprepared for the real estate crash of 2007-2009.



If you’re going to invest in real estate directly, you lose substantial tax benefits by doing it in an IRA. “The tax advantages are wasted in an IRA,” says William Fleming, managing director of personal financial services for PricewaterhouseCoopers in Hartford, Connecticut.

You lose the ability to deduct mortgage interest payments from your taxes — a deduction that is available for homes purchased outside an IRA. And you lose the depreciation benefit that would allow you to write off the value of a residential property over 27 years, or maybe even sooner if you bought it outside an IRA, says Richard Rampell, CEO of Rampell & Rampell, an accounting firm in Palm Beach, Florida.

Moreover, if you sell property outside your IRA, your profit is subject to a capital gains tax. But any profit you garner from selling real estate inside an IRA — unless it’s a Roth IRA — is ultimately taxed at your ordinary income tax rate, which will almost certainly be higher than the capital gains rate.”I would almost never recommend for someone to invest in real estate in an IRA, except for REITs,” Rampell says.



Not only do you lose tax benefits by investing in real estate within an IRA, you may incur additional tax liability. For example, if you take out a mortgage on the property, you will be subject to an unrelated businesses income tax on a percentage of the rental payments you receive. For example, if you make a 30% down payment on the property, which is often required for a mortgage loan within an IRA, then 70% of your rental income is subject to the tax.

“That defeats the purpose of retirement investing,” which is to minimize taxes, says Amy Logar, director of retirement services for PNC Wealth Management in Cleveland.

There are also transactions that are prohibited within the IRA. The IRA can’t purchase real estate from the IRA owner or his or her family. And the IRA can’t sell the real estate to the owner or family members upon distribution. The owner also can’t live in a home while it’s in the IRA. So don’t expect to pick up a home where you can move right in.

If you inadvertently break these rules, the penalty is big: Your IRA can be disqualified, creating a taxable distribution for the entire IRA.



Buying property in an IRA is a far cry from establishing an IRA with your discount broker and then buying stocks or mutual funds in it. You have to find a custodian to open a self-directed IRA, and custodians don’t come cheap. For example, at Millenium Trust Co. of Oak Brook, Illinois, it will cost you $50 to open an account; a $300 annual fee, regardless of your account’s size; $125 in holding fees for each asset; and a $250 transaction fee for each real estate purchase.

“You have to make sure your property is properly titled in the IRA with the custodian’s consent,” Logar says. “All the money has to flow in and out through the custodian. Circumventing the custodian could cause a transaction to be deemed a distribution from your IRA.” That could mean tax penalties.

Also, because self-directed IRAs are less regulated than conventional IRAs, there is more room for fraud, experts say. “That’s one of my biggest concerns,” Ahamed says. “A lot of uninformed investors go on the Internet and see a website saying this is the best thing since sliced bread. Maybe 3 or 4 providers know what they’re doing.”



Any money you spend for improvements, maintenance, insurance and taxes on the property has to come directly from your IRA. That means your IRA has to hold enough cash to make these payments, and you’re probably going to have to hire a property manager as well, experts say. “You’d better have enough cash in the IRA to pay plumbers, electricians and other repair people,” Fleming says.

In addition, beginning this year, IRA custodians are required to report annually to the IRS the fair value of non-marketable assets, Logar says. That would include real estate, of course. “And any expense to attain a valuation or an appraisal, that has to be paid from the IRA,” she says.

Remember that the amount of money you can add to your IRA each year isn’t very large — $5,500 this year, or $6,500 if you’re at least 50. Rent payments from your property will provide some cash. But remember: That cash flow isn’t guaranteed. Depending on what happens to the real estate market, you may have to lower your rental rates at some point. And deadbeat tenants might skip out on their rent payments.



One goal in retirement investing is diversification, and snapping up individual properties does little to advance that goal, especially if you already own a home, experts say.

“For IRAs or any retirement account, you want to think about them as a completion of your portfolio. It’s what you use to diversify the other risks in your life,” Benz says. “By taking a narrow focus on individual properties, you’re running against that concept. You might actually add to the riskiness of your profile. That’s the biggest picture argument” against real estate investing in self-directed IRAs, she says.

Many people own their homes and have much of their equity tied up in them. “They would want to think about diversifying that risk,” Benz says. “It’s not a good idea to double down on real estate.” The real estate market can go through great volatility of its own, as seen in the boom of 2001-2006 followed by the bust of 2007-2009.

If you want a diversified exposure to real estate, consider REITs or real estate mutual funds, experts say. “That’s where asset allocation comes in,” Fleming says. “There’s less risk and more liquidity.”