Grounding Your IRA

By Corrie M. Anders
San Francisco Chronicle
Sunday, January 26, 2003

It's a little known strategy but the stock market-way can roll retirement into real estate.

If you're squeamish about parking your IRA nest egg in the wobbly stock market, there's an alternative investment that few people know about. It's real estate.

Individual Retirement Accounts that invest in real estate have been around for more than 25 years. But they have only started to gain public attention during the past two years as huge chunks of wealth have evaporated in the stock market.

While these “real estate IRAs” have their own, sometimes complicated rules of the game, there's virtually no limit to the type of residential or commercial transactions allowed. Single-family houses, apartment buildings, farms, shopping centers, office buildings, hotels, trust deeds, tax lien certificates and raw land all qualify.

Separate IRA accounts also can be pooled to form limited partnerships or limited liability corporations to increase buying power. The partnerships range from spouses who merge their separate IRAs to people with fairly new IRAs that haven't yet accumulated substantial savings.

“You name it and you can invest in it,” said Patrick Rice, president of IRA Resource Associates, a Camas, Wash. , firm that facilitates such deals. The IRS code “doesn't tell you what you can invest in. It tells you what you can't invest in.”

Out, for example, are collectible coins or rare liquors. Neither can your IRA invest in a Chagall masterpiece, antique cars or life insurance.

Business is up – way up

Some 35 million households own approximately $3 trillion worth of IRAs, mostly invested in stocks and bonds sold by brokerage houses, banks, mutual funds and insurance companies. Less than 1 percent of the retirement money involves real estate or other nontraditional investments, according to Rice.

That's changing, as more people become aware of the real estate option. Rice noted that the amount of money flowing into his company for real estate IRAs has quintupled over the past two years.

Traditional IRAs – in which individuals this year can contribute a maximum $3,000 annually, or $3,500 if you're age 50 or over – have been allowed to hold real estate since the program's inception in 1974. Still that option comes as a surprise to most ordinary IRA savers – and to many professionals as well.

“I spoke to 40 Alameda County real estate attorneys recently, and most didn't know you can do this,” said Tom Anderson, CEO of PENSCO, a bank based in San Francisco that specializes in the administration of IRAs that invest in real estate.

No profit for stockbrokers

The reason you haven't heard about them is that there is little profit incentive for financial institutions, which primarily sell stocks and bonds to IRA accounts. “Why would they tell you about real estate?” said Rice. “That would mean the money would go out of their pots and they couldn't make money on it anymore.”

Real estate IRAs might be tempting for anyone who's watched the value of Bay Area real estate skyrocket during the past few years. People with Keoghs, SEPs, Roth IRAs – or those who have rolled their 401(k)s into an IRA after retiring or changing employers – also are eligible.

In addition to potential appreciation, the capital gains tax on an IRA-sold property can be deferred – or eliminated in some cases. Another bonus is that any rental income goes directly into the IRA account.

Pitfalls and penalties

Keep in mind, however, that real estate goes through its own boom-bust cycle. Values could be stagnant or in decline when it's time to sell your holdings. And real estate IRAs have potential pitfalls with harsh financial penalties for transgressions.

Most savers will want to work with experts to help convert a traditional IRA into a self-directed IRA – one that you control – and to help you stay within the rules. They include IDA custodians, who act as trustees for the account; IRA advisers, who locate real estate investments; and IRA administrators, who handle record-keeping chores, including collecting rents and paying bills.

“We don't recommend this for people who are not sophisticated investors or not working with advisers,” said Anderson .

One sticky area for IRAs holding real estate is self-dealing, which is a no-no. a beautiful house at the beach and a gorgeous weekend may seem awfully alluring. But neither you and your spouse, nor your parents, nor your children can own or use the property as a personal residence. (Strangely, your sister or brother can). Likewise, you cannot use your IRA's commercial space for your own business.

Break the rule and you could lose, including penalties, anywhere from 15 percent to 155 percent of your IRA's value.

Another potential quagmire: Once an IRA purchases a property, the account must contain enough cash in reserve, or have enough rental income, to cover operating expenses. You also need funds for emergencies “in case a water heater breaks, or you lose a tenant for a couple of months” said Debra Greenstein, president of Entrust Administration of Oakland.

If the account has inadequate funds, you can put in new cash to cover the shortage. But the IRS will slap you with a 6 percent penalty on any additional contribution beyond the maximum annual limit. The penalty doesn't stop until the excess contribution is removed from the account.

Mandatory distribution

Property management can post a considerable expense – from 6 to 10 percent of monthly rents – and it may not be cost-effective for individual houses and small apartment buildings. Some IRA facilitators will let you collect the rent check and send it to them uncashed – or let you arrange for a plumber to make repairs, but have the facilitator pay the bill from the IRA account.

IRA holders must also be cautions about mandatory distribution. The IRS requires that you must start to take mandatory distributions from your retirement account once you reach 70 1/2. So the IRA must generate enough income to provide for the distributions. Otherwise, the IRS will assess another onerous penalty – a hefty 50 percent on the amount of the minimum distribution you should be receiving.

There are several ways to raise funds if your IRA needs cash for emergencies or mandatory distributions. Funds can be merged in from another IRA, the real estate can be refinanced, or it can be sold.

Real estate IRAs with mortgages can also run afoul of the Unregulated Business Income Tax (UBIT). It goes into effect when the leveraged real estate produces profits of $1,000 or more in any one year. The hit is up to 39.6 percent of the capital gains beyond $1,000.

For many smaller properties, expenses offset any income. Still, applying the excess gain to the loan principal can mitigate the UBIT situation. And the tax burden disappears once the loan is paid off.

“You can pay off the principal and wait one year,” said Anderson . “Than at the time of sale, the capital gains will go direct into the IRA tax-deferred. And if it's a Roth IRA, it's tax-free.”