Think Real Estate For Your Retirement

Posted on January 6, 2012 by JacksonvillesRealtor

With the uncertainty surrounding stock market investing in today’s post tech-bubble environment, solid and consistent returns on retirement portfolios are harder to come by. On the other hand, real estate has been outperforming the stock market now for some time. So, why not devote a portion of your IRA or 401(k) to investing directly in real estate?
Now you can. In fact, since retirement planning is an inherently long-term activity, real estate can be suited ideally for these types of portfolios. As in most things, there are pros and cons, and you need to be aware of the rules. Since IRAs and 401(k)s are tax-deferred accounts, failure to follow the rules exactly may have unforeseen (and substantial) unfavorable tax consequences.
The first thing to bear in mind is that real estate can produce income and appreciation only. Since the amounts in IRAs and 401(k)s are shielded from taxation, there is no depreciation available to aid in the investment return, as is normally the case.
Under the law (Section 408 of the Internal Revenue Code, in case you want to look it up), a retirement account may invest in any kind of real estate, from undeveloped land, to single-family homes and condos. The income and appreciation accumulates mostly tax-free, until you begin taking distributions from the account. There is some income tax owed, however, on income produced to the extent that the property is financed.
For example, if you wish to purchase a $200,000 home using a mortgage to finance 40 percent of the amount, then, 40 percent of the income is subject to ordinary income tax. The remaining 60 percent of the income is tax-deferred in the normal manner.
This problem can be overcome by partnering with others to buy the property. This is especially attractive since financing can sometimes be difficult, as the debt must be a non-recourse promissory note.
As mentioned above, there are plenty of rules governing how these accounts work. First off, you need to transfer your account to an independent custodian that offers real estate as an investment option. You cannot invest in real estate from an IRA that you control — the account must be maintained with an independent manager and cannot be self-directed.
Other limitations are that you cannot transfer any existing property into a retirement account, nor can you purchase a vacation home and rent it to yourself or to your “lineal” family members (that means parents, spouses and children — siblings are allowed).
Also, your business cannot lease space in a property held in your IRA. The idea is that this is an investment purchase and not one from which you will derive any immediate personal benefit.
However, you can purchase investment property and rent it out to third parties. Rents are received directly into the retirement account and expenses are paid out of the account.
Note that if your account does not have enough cash to meet its operating expenses, you will need to withdraw the property from the IRA, thus exposing you to early withdrawal penalties as well as income taxes.
So, while real estate in retirement accounts can be an attractive investment vehicle offering long-term income and appreciation potential and adding to the diversification of retirement portfolios, it also comes with unique risks and requirements. As always, consult with a qualified financial adviser before investing and make sure all angles are covered.