A well-located and well-run hotel is a proven moneymaker. Paris Hilton didn’t get all those designer handbags because her family was broke! Like most real estate investments, hotels and motels provide a combination of regular income with the potential for capital appreciation. While lodging businesses are more labor and resource intensive compared to traditional residential landlording, they also provide more revenue opportunities, such as vending, restaurant leasing, event hosting, banqueting, catering and advertising, to name a few. And it’s perfectly legal to own them within a Real Estate IRA.
REITs vs. a Real Estate IRA
If you like REITs, you should love Real Estate IRAs, if you’re a long-term investor. Many investors are attracted to owning real estate within a REIT, or real estate investment trust, because of the tax efficiency. The problem with owning a straight C corporation is taxation: Dividends are not tax deductible to the corporation. So the C corporation owner pays taxes at the high corporate level, and then has to pay them again as ordinary personal income when he or she receives income from the underlying properties. That’s a tax double whammy.
The advantage of a REIT is that as long as the REIT pays out at least 90 percent of its revenues as dividends, and as long as the company maintains at least 75 percent of its portfolio in real estate and receives at least 75 percent of its income from real estate. If all three requirements are met, then the REIT does not pay tax at the corporation level. Everything flows through to the individual tax return, and you pay tax on the income, though you can still qualify for capital gains rates when you sell REIT shares at a profit.
That’s a big tax efficiency improvement compared to C corporations. But if you are tax sensitive, or if you are in a high-income tax bracket but you still want income, then consider direct ownership of real estate within a Real Estate IRA.
With a Real Estate IRA, all income from rents is tax deferred, as are all capital gains. This is true as long as the assets remain in the account. If you own the property within a Roth IRA, then all income and all capital gains are tax free, provided the money stays in the Roth account for at least five years.
While many investors choose to gain exposure to the real estate/lodging asset class via owning a REIT, or even a REIT mutual fund, skilled investors may do even better owning hotels, motels or other lodging businesses more directly within their own IRAs.
One key advantage: Investors who purchase properties directly, rather than relying on the stock market, are often able to buy at deep discounts relative to future cash flows. By avoiding a liquidity premium and a large company premium, and judiciously employing leverage, income-focused investors can frequently get a superior income on invested capital.
Before you make the leap, remember that you must obey certain rules when it comes to owning a lodging business within an IRA:
You cannot hire your spouse, children or grandchildren as staff (nephews and siblings are ok under current law). You also cannot hire them to do contracted work such as management, catering or landscaping. The same goes for your parents, your spouse’s parents and any entities they own. Otherwise you could violate prohibited transaction rules.
Furthermore, you can’t rent or lease space to yourself, nor any of the individuals mentioned above. You can’t let them stay in your property, even if they pay a fair market rent, and you cannot stay overnight in your own property. You also cannot pay yourself a salary for running the hotel on a day-to-day basis, or you could violate self-dealing rules. Doing so will likely violate
Do not mingle personal and investment funds. You can’t even stop at the market on the way to check on your policy and pick up a few light bulbs for your own property using your own checkbook or debit card. All purchases and contracts associated with your Real Estate IRA property must be paid using money from that IRA.
Hotels and motels can be liability-generating businesses, so it’s important to maintain liability, umbrella and other essential forms of insurance coverage, and to hold the property within an entity that walls it off not only form your own personal assets but from other assets held within your retirement account.
Those are the basics of owning hotels and motels within a Real Estate IRA. More information on hotel and motel purchase and ownership within a Real Estate IRA in an upcoming post.