Using Your IRA to Buy Real Estate

(Image credit: KaraGrubis)

published 2 November 2016

Question: I'd like to invest in a rental property. Can I use my IRA to buy real estate?

Answer: In order to invest money from a traditional or Roth IRA in rental property, you must first set up a self-directed IRA. Some companies, such as Equity Trust and Entrust Group, specialize in self-directed IRAs that invest in real estate.

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You’ll need a significant amount of money in your IRA because you’ll probably want to pay cash for your rental property. If you borrow to finance the property, you’ll run into the unrelated business taxable income (UBTI) rule, which could require you to pay hefty taxes on your rental income and profits when you sell inside the IRA, says David Hultstrom, a certified financial planner (CFP) in Woodstock, Ga. That’s right: Income inside the tax shelter would be taxed as it is earned and, because you’ll also have to pay taxes when you withdraw funds from your IRA, you’ll be taxed twice.

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In addition, you must pay others to do work on the property, using funds from the IRA, even if you’re capable of doing the work yourself. Run afoul of these rules and your IRA could be disqualified, triggering taxes and early-withdrawal penalties (if you’re younger than 59½) on the entire amount.

Landlords typically enjoy a host of tax write-offs for depreciation, property taxes and other expenses. When you own the property in an IRA, however, you can’t claim any of those tax breaks. Worse, if you own the property in a traditional IRA, profits will be taxed at your ordinary income tax rate, not the more favorable capital-gains rates. (If you own the property in a Roth, it isn’t an issue because gains are tax-free.)

10 Things You Must Know About Traditional IRAs

Finally, if you own the property in a traditional IRA, you’ll encounter major hassles when the time comes to take required minimum distributions. Once you turn 70½, you must take annual withdrawals from all of your tax-deferred accounts, based on the year-end balance of your IRAs. To determine the year-end value of a piece of real estate, you must obtain an appraisal, says David Mendels, a CFP in New York City. Appraisals are expensive—the average cost is about $300—and subject to interpretation, which means a lowball number could be challenged by the IRS. (This doesn’t apply if your property is in a Roth IRA because you don’t have to take RMDs from a Roth.)

A better choice. There are other ways to invest in real estate in your IRA that won’t jeopardize your account’s tax-advantaged status. One good option is a real estate investment trust. REITs own property such as apartment buildings, offices, malls, warehouses and hotels. They’re required to return at least 90% of taxable income to shareholders, so dividends are typically generous. REIT stocks yield 3.9%, on average, compared with 2.1% for the S&P 500. If you’d rather invest through a mutual fund, you have plenty of choices. Kiplinger’s top picks include Manning & Napier Real Estate S (symbol MNREX) and Fidelity Real Estate Investment (FRESX), with one-year returns of 20% and 21%, respectively. If you want to simply track the REIT market, Schwab U.S. REIT ETF (SCHH), an exchange-traded fund with a one-year return of 18%, follows the Dow Jones U.S. Select REIT index.

Because dividends are always taxed as ordinary income, IRAs provide a tax-efficient way to invest in REITs. In a traditional IRA, taxes on the dividends will be deferred until you take withdrawals. If your REITs are in a Roth, dividends—along with all other earnings—are tax-free.

5 High-Yielding REITs for Dividend Investors

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Block joined Kiplinger in June 2012 from USA Today, where she was a reporter and personal finance columnist for more than 15 years. Prior to that, she worked for the Akron Beacon-Journal and Dow Jones Newswires. In 1993, she was a Knight-Bagehot fellow in economics and business journalism at the Columbia University Graduate School of Journalism. She has a BA in communications from Bethany College in Bethany, W.Va.