There’s always been a friction point between real estate professionals and finance professionals, and maybe it’s inevitable. It has to do with the basic difference between the underlying assets driving each of them.
Financial types are, of course, focused on money. And money is fungible. One dollar is exactly like the next, so they have structured one share of a company’s stock to be identical to all the others, and one corporate note to be the same as any in the series.
While understanding that none are to be fallen in love with, real estate purveyors can tell you in detail what makes each property unique, from the shape of the lot to the demographics of the community around it to the condition of the utilities running beneath it.
When one considers that money and property are the twin pillars on which the wealth of nations rests, you can see that members of Team Money are going to have some blind spots when it comes to handling the property. (The inverse is probably true about Team Property, but maybe that’s a topic to be addressed in the future.)
And that’s why a lot of financial advisors may be under the impression that you shouldn’t – or maybe that you can’t – invest in real estate as part of your retirement portfolio. Whether they are uninformed or misinformed or deliberately resistant to the notion, they are wrong.
What Makes Self-directed IRAs Different?
Let’s start at the beginning which, when it comes to U.S. retirement plans, is 1974. (Up until then, there was the defined-benefit pension, which is now racing the Asian elephant to the point of extinction.) When Congress passed the Employee Retirement Income Security Act, it opened the door to, among other vehicles, individual retirement accounts.
In the decades since ERISA, there’s been a lot of legislative tinkering. The biggest came in 1997 with the introduction of Roth IRAs. A traditional IRA taxes your income upon withdrawal and a Roth taxes you upfront.
“Since the banks and brokerage houses which acted as custodians focused solely on selling stocks, bonds and mutual funds, their accounting systems and administrative policies were only geared to those areas. They were neither willing nor able to handle their IRA account holders’ wishes to purchase or invest in real estate, private businesses, commodities, intellectual property, coins, etc.,” according to an unsigned article on the Broad Financial website. So “several trust companies with the administrative flexibility to hold alternative assets entered the IRA arena. As a result, a new level of diversification became possible for IRA investors, one that truly permitted an IRA account holder to ‘self-direct their retirement assets.”
Thus 1997 also brought the self-directed IRA – which can be structured as either a traditional or a Roth account. It brings special privileges, although it also brings an added layer of complication.
The problem with other IRAs – including models designed for small businesses and the self-employed – is that they’re run by fiduciaries who, to be fair, are paid to be risk-averse. They’re the ones who’ll tell you, “You’re not Gordon Gekko. You’re not The Wolf of Wall Street. You’re a 58-year-old orthodontist from Parsippany. Buy Duke Energy and gift the GameStop shares to your kids.”
And that’s fine for most people, but some of us don’t want the dice taken out of our hands. That’s why The Government decided to provide one type of IRA that allows for alternative investments. Immediately after, the Government lost a lawsuit.
James and Josephine Swanson of St. Petersburg, Fla., turned their IRA into a blank-check company – what would now be called a SPAC – and sold their S-corp hardware company and import-export company to that shell, which also bought their old house in Algonquin, Ill. The Internal Revenue Service refused to allow these entities to be taxed under the more favorable ERISA rates, so the Swansons sued the IRS commissioner. They won, so now self-directed IRAs are a thing.
Real Estate Rules
This raises the question: What can you invest in via a self-directed IRA? Rachel Hartman at U.S. News and World Report and Jean Foger at Business Insider breaks it down:
- Promissory notes
- Private equity
- Tax lien certificates
- Gold, silver, and other precious metals
- Water rights
- Mineral rights
- LLC membership interest
- Horses and livestock
- Intellectual property
And, of course, the list wouldn’t be complete without real estate, including farms and undeveloped or raw land. These are, in fact, the most popular investments in self-directed IRAs, and private mortgages are also on the approved list.
The non-approved list is much shorter: collectibles, life insurance or real estate you live in.
Even so, there are rules to follow when investing these retirement funds in real estate. Jessica Willens outlines seven of them for the Real Wealth Network:
- Property cannot be owned by you. Your IRA is not allowed to purchase property that is owned by you or a “disqualified person.” According to The Entrust Group, an administrator for self-directed IRAs, disqualified persons include your spouse; your parents, children, or grandchildren; your spouse’s parents, children, or grandchildren; your employer; anyone offering plan-related services such as custodians, advisors, or administrators; and any entity in which you directly or indirectly own at least 50%.
- You cannot have indirect benefits. You cannot have indirect benefits from property that is owned by your self-directed IRA. These might include renting the garage apartment in a house that your IRA owns.
- Property must be uniquely titled. You and your IRA are considered to be two separate entities; as such, investments should be titled in the name of your IRA.
- Property can be purchased with combination funds. You can purchase real estate in your self-directed IRA in combination with other funds.
- Your IRA must pay Unrelated Business Income Tax if financing. Any IRA investments that use financing are required to pay UBIT because the assumption is that it is engaging in operations that are contrary to the tax-advantaged mission of a retirement account.
- Expenses must be paid from the IRA. These expenses might include building association fees, utility bills, maintenance fees, renovations, and property taxes.
- Income generated must return to the IRA. Any and all income that is generated by property owned within a self-directed IRA is required to be paid directly back into it.
Why Bother Investing in Real Estate?
Let’s be clear: A lot can go wrong by holding commercial real estate in your self-directed IRA.
Not every financial institution that serves back-office functions for traditional IRAs will provide the same services for a self-directed one. Also, recordkeeping and tax reporting are more complex. As a result of both of these factors, maintenance fees can be high – and so can the IRS penalties. And when you consider that custodians and trustees have limited duties related to asset selection – that’s what the account holders wanted to do in the first place – the field is ripe for fraud.
Also, you can’t borrow against your self-directed IRA, nor can you lend it to any of those disqualified persons. And you can’t take advantage of many of the alternative investment opportunities presented by the self-directed IRA unless you’re also an accredited investor. One more issue presented by this vehicle is that, like most IRAs, you can only contribute $6,000 per year up to age 50, then only $7,000 per year.
Of course, there are also the usual risks of betting on a piece of real estate, not the least of which is that it can prove to be highly illiquid at a most inopportune time.
So maybe the way to invest in real estate for retirement is to do what your fiduciary has been telling you all along: Just buy REITs. On top of all the other benefits of being securities rather than underlying assets, they’re tax-advantaged.
But wait. So are IRAs. Is there any benefit to keeping tax-advantaged securities in an otherwise tax-advantaged account? Sure, it’s likely to become a bit diluted.
So maybe it makes more sense to use the IRA as a tax shield for what might otherwise be a fully taxable event, such as the purchase of a building or of a partnership in a real estate limited partnership.
The benefits of a self-directed IRA all come down to the two reasons you’d want to engage in alternative investing – diversification and higher potential returns – combined with the one reason why you’d open a qualified retirement account – favorable tax treatment.
Whether to invest via a self-directed IRA or via another account is not a no-brainer decision. If you have the funds to commit to this venture, perhaps the first money spent should be to your accountant.