The Creative Investor - Don't Overlook Real Estate in Retirement Investment Planning

Are your clients interested in purchasing real estate for investment purposes, but don’t have enough cash on hand to do so? Maybe they do! There is a long-standing Internal Revenue Code regulation (see IRS publication 590 for complete regulations) that allows all Americans to invest their IRA funds, or 401(k) funds rolled into an Self-Directed IRA, in a wide variety of non-traditional investment types. Under the

umbrella of a Self-Directed IRA, retirement account funds can be invested in such non-traditional assets as private mortgages, raw land, commercial buildings, vacation rentals, and multifamily homes, just to name a few. Keep in mind that your clients do not have to “cash out” their IRA to do this type of investing – these investments are made within a Self-Directed IRA. Your customer can simply transfer funds from existing IRAs or a 401(k) account that is from a previous employer, into a Self-Directed IRA to do this type of investing and it is penalty-free. Additionally, the taxes due on the growth of the investments are deferred until distribution begins at retirement. If the Self-Directed IRA is in the form of a ROTH IRA, both the principal and earnings are tax-free when distributed at retirement.

Let’s consider a real life example of how investing in Real Estate within a Self-Directed IRA can be a lucrative retirement strategy. Steve is interested in purchasing an office building with his IRA funds. He has found a building in a growing executive park, which is 100% occupied. The asking price is $400,000 but he only has $200,000 in his IRA. The current owner of the office building is willing to do seller carry-back for the balance of the loan. Therefore, Steve’s IRA has directly funded 50% of the purchase price and has financed the remaining 50% with the seller carry-back mortgage of $200,000.

Rental income from the office building now flows directly back to Steve’s IRA as a return on investment. His IRA uses a portion of that income to pay off expenses related to the running and maintenance of the building, such as the monthly mortgage payment to the seller, insurance coverage, property taxes, snow plowing and so forth. At the end of the year, the building owned by Steve’s IRA will have a net income of $20,000, after all expenses are paid.

However, since Steve’s IRA used financing to make the purchase, the portion of the income that is attributable to the financing is subject to Unrelated Debt-Financed Income, or UDFI. In Steve’s case, since his IRA financed 50% of the purchase price, then 50% of his net income, or $10,000, would be subject to UDFI tax. Since UDFI is taxed at ordinary trust tax rates, often as high as 40%, he will end up paying approximately $4,000 in UDFI taxes. However, his IRA will still end up with a net gain of $16,000 for the year (ROI of 8%). Even though his total IRA income was impacted by the UDFI tax, his net gain is still much more than the IRS limitation of annual contribution of $3000, or even the return on most publicly traded investments.

Twelve months after the debt is paid off, UDFI ceases to apply to the net income generated. Steve’s IRA will then continue to earn rental income and years down the road, when he is ready to retire, his IRA can sell the office building realizing the appreciated profit and all capital gains from the sale flow back to his IRA as a return on investment. When he retires, his IRA distributions are taxed at his lower, retired tax bracket. If he makes this investment with a Self-Directed Roth IRA, all of the return on investment is tax free upon distribution.

You may be wondering “what’s the catch?” While there is some paperwork involved, it is not much more than would be required if your customers were to purchase property without their IRA. There are also specific ways investments must be structured if your customers are using both their IRA and their own personal taxable funds to make a purchase. And, of course, they will need a reputable qualified special asset custodian who is willing to hold alternative assets such as Real Estate within a Self-Directed IRA in order to make it all possible. It’s always a good idea for your customers to contact their own financial or legal advisor to learn more about how they can take advantage of this little-known retirement strategy and start putting it to work today. Investing in the potentially lucrative area of Real Estate with a Self-Directed IRA is a lot easier than your clients may think! It also can potentially be the catalysis in closing substantially more sales in 2004 for you.

For more information on PENSCO Trust Company or Self-Directed IRAs, please click on my profile.