Believe it or not, you are allowed to hold real estate in your individual retirement arrangement (IRA). However, real estate is a complex asset and many IRA trustees will simply not allow you to put real estate into the IRA that they serve as custodian of. Nevertheless, there are plenty of independent trustees available that will allow you to hold various “exotic” assets, including real estate.
The tax code – as enforced by the Internal Revenue Service (IRS) – has strict guidelines about what can and cannot be done with real estate in an IRA and a violation of prohibited transactions rules can result in a financial disaster as your IRA is automatically dissolved and you not only lose all tax advantages but end up owing all the taxes that would have been due had the money not been in an IRA at all. For example, you are not allowed to live in – or allow people closely related to you – to live in any real estate you may have in your IRA. This begs they question: why would you want to put real estate in your IRA? There are two reasons for doing this, either for tax deferment or tax free appreciation.
Tax deferment stems from the use of a Traditional IRA. In a Traditional IRA your contributions are deductible and you do not have to pay taxes on the money inside the IRA until such a time as you begin withdrawing it. However, once you begin withdrawing money from the IRA, all the regular amounts of taxes will be due and must be paid on whatever amount you withdraw. If you have enough money in your Traditional IRA to buy real estate and enough liquid cash in the IRA to pay all of the maintenance fees (like property tax) associated with the real estate, tax deferment can be a wonderful thing. Once you are ready to retire, you have the real estate distributed to you (taxes will be owed) and then move into your retirement home. However, this only really works for people with multiple retirement plans and a lot of ready cash immediately available.
For tax free appreciation, the real estate has to be held in a Roth IRA. You can either convert a Traditional into a Roth (paying taxes in the process) or you can have a separate Roth. However, just as is the case with cash, you have to pay taxes on any contribution to a Roth IRA, though any gains made afterward – inside the IRA – are tax free. The Roth strategy is probably the best option for someone unlikely to retire for a long time and who is in a position to buy a house outright. However, using this strategy offers virtually no immediate tax benefit and if the property depreciates in value, it is likely that you will lose money.
In either case, putting real estate inside an IRA is a complex endeavor because it has direct ramifications on many different aspects of your tax situation. For example, you cannot claim any sort of deduction on your personal return related to the real estate once it is in the IRA. Similarly, the rules governing the IRA itself have to be taken into account as well, for example: IRAs have set contribution limits, so you have to take this into account. Before deciding to put real estate into your IRA, you should really consult with an IRA expert as well as an overall financial planner to determine if the move is a good one for you and if so how to go about doing so in a proper fashion.