Tax planning and compliance for investors
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By Kaye A. Thomas
Updated January 26, 2008
Risk of prohibited transactions makes this a poor choice.
The real estate bubble had a lot of people thinking about how they could use it to get rich. One idea was to use an IRA to invest in real estate. Apart from the usual risks of investing in a bubble, which have now come home to roost, this approach can lead to a major disaster if you run afoul of the prohibited transaction rules. Never heard of these rules? You'd better study up if you're thinking about using your IRA to invest in real estate.
Certain kinds of investments are prohibited in IRAs. These are generally described as "collectibles," including such items as artwork, antiques, gems, stamps and coins. (There's an exception for certain coins that are used primarily as a way to invest in precious metals.) Real estate is not a prohibited investment. But there's a completely different rule that may cause a prohibited transaction when you invest your IRA in real estate.
A prohibited transaction occurs when you interact with your IRA in certain ways. Here are some of the things you aren't allowed to do:
You aren't allowed to do any of these things directly or indirectly. That means you can't avoid this rule by having your IRA deal with a company you own, or with a family member. And these are outright prohibitions: they aren't allowed even if you do everything in a fair and reasonable manner.
Many people who buy real estate in their IRAs are unaware of these rules. Companies that promote real estate investments for IRAs may mention the issue in general terms, but rarely make adequate disclosure. They don't want to discourage you from using their services, so they make a vague reference to some rules you should discuss with your tax professional. They're aware that many of their customers won't bother to check with a pro, and besides, there are plenty of tax professionals who don't know these rules.
Looking at the list above, you can see how easy it would be to violate the rules if you hold real estate in your IRA. Even if your IRA purchases the property from an unrelated party, you'll have a prohibited transaction if you provide services to the IRA.
Suppose you have your IRA buy a broken-down property and fix it up so the IRA can sell it at a profit. That seems like a great way to add value, but if you personally do the remodeling work, or do it through a relative or a business you own, the IRS may say you've made a prohibited transaction because you're providing services to the IRA.
Suppose you have your IRA buy a rental property. Who is going to find tenants, collect rent and perform other management services? If you do this, or have a related person or business do it, here again the IRS may say you have a prohibited transaction.
What happens if you have a prohibited transaction in your IRA? It's almost unbelievably bad. The IRA is considered terminated as of the first day of the year in which the prohibited transaction occurred. Here's what that means:
In short, you've nuked your IRA. In fact, the entire account is wiped out even if you only used part of it for the prohibited transaction.
So far we've seen little activity in this area on the part of the IRS. That's probably because very few people have used their IRAs this way prior to the current real estate bubble. With the increased use of IRAs to invest in real estate, it's reasonable to be concerned that the IRS will become more active. In that case this will probably be an easy area for the IRS to audit, because most of these IRA accounts are at a small number of firms that have been promoting this kind of transaction.
There are plenty of other reasons to avoid putting real estate in an IRA. Lack of diversification, the high risk of investing during a real estate bubble, loss of tax benefits such as depreciation deductions, possible application of the unrelated business income tax . . . the list goes on. This is a lousy idea even before we consider the prohibited transaction rules.
If you want real estate in your IRA, use part of the account to buy shares in a REIT, or a mutual fund that holds REIT shares. You get diversification and professional management, and you avoid all the headaches — including the risk of nuking your IRA with a prohibited transaction.
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