The direct ownership of real estate within a self-directed IRA or other retirement account is increasingly popular. A lot of people are attracted to real estate due to the potential for leverage, better perceived potential returns than they expect to get in stocks and bonds, and the increase in control they have over their investments. The powerful tax-deferred and tax-free advantages afforded by self-directed IRAs coupled with the fact that you do not have to pay capital gains taxes on properties held by your IRA add to the appeal of holding real estate in your self-directed IRA.
In return for these tax advantages, the IRS imposes some limits on what you can do with property you own in your self-directed IRA. Key among them is the prohibition against self-dealing. For example, neither you, your spouse, your descendants or ascendants, nor their spouses, nor any entities they own or control may use the real estate for their personal use and/or benefit.
That said, however, IRS rules open up a very attractive strategy for some of our clients: You can use your self-directed IRA to buy yourself a retirement home. Simply buy the property using your IRA, then rent it out until you reach retirement age. Any rent income you receive within the IRA will be tax deferred (in a traditional IRA or other retirement account such as a self-directed Solo 401k, SEP-IRA or SIMPLE IRA), or tax-free (in a Roth IRA).
This strategy works well for people who are confident they won’t need to use the home themselves until they are at least 59½.
Once you reach 59 ½, you may continue to use the home as an investment property or you may take the home as a distribution so that you can move into your retirement home.
By using this strategy, you effectively prepay the cost of your retirement home. You lock in your retirement home at today’s prices, using money you were already going to contribute to your self-directed IRA.
Taking the Distribution
Once you take the property as a distribution, the IRS will then require you to record the fair market value of the property, minus any tax basis, on your federal income tax return. If you hold the account in a Traditional self-directed IRA and you made no non-deductible contributions, your tax basis would, of course, be zero. You would recognize the entire fair market value of the property as gross income in the year you took the distribution. If you made non-deductible contributions accounted for on IRS Form 8606, you would get credited toward your tax basis for these contributions.
Naturally, taking a large asset such as a home as a taxable distribution could cause quite a tax hit potentially creating a significant tax burden.
To avoid this issue, many people buy the home using a Roth self-directed IRA. This way, all the rental income prior to you taking the distribution is tax-free, as opposed to tax-deferred. Furthermore, there is no income tax due on the distribution. Distributions from Roth IRAs that are at least five years old are tax-free. A Roth IRA is the ideal vehicle for this strategy.
How To Do It
To execute this strategy for your own portfolio, do the following:
- Open an account with American IRA.
- Fund your American IRA account. You can use new money (subject to annual limits), or money you roll over or transfer from other retirement accounts.
- Identify the property you want to own.
- Provide us with detailed written direction to purchase the property on your IRA’s behalf.
- All profits and expenses flow through your self-directed IRA.
Any time you have a self-directed IRA, it’s important to use a qualified third-party administrator with expertise in handling these kinds of accounts. American IRA specializes in self-directed IRAs and other accounts. Our job is to make sure your assets are titled appropriately and to make sure your transactions are carried out in accordance with IRS guidelines. We do not provide specific investment or tax advice. Instead, as a third-party administrator, we work with your team of professionals to ensure your instructions are carried out efficiently and in accordance with the IRS guidelines.
To begin the process, or to obtain more information, call American IRA today at 866-7500-IRA (472). We look forward to hearing from you.