The financial services industry has invented and promoted many ways to rip off people. Fake bank accounts, excessive and unauthorized account churning, non-traded REITs, cross-selling high fee products, pump and dump stock schemes, egregious variable annuity sales, and probably another financial abuse strategy exposed in the business section of this morning’s newspaper. In fairness, there are lots of good actors in all segments of the financial services space including insurance salespeople, commissioned stock brokers, and mortgage brokers. At the same time, there are a lot of bad actors selling overpriced products and strategies with poor transparency that the end consumer does not need. Somewhere high on the list are bad actors promoting the purchase of rental real estate inside a tax deferred retirement account such as a traditional IRA or 401k. While this can be sold as a compelling strategy, it rarely ever is a good idea unless the goal is merely a transfer of wealth from your retirement account to the salesperson’s bank account.
So why do financial services professionals promote the use of tax deferred IRA and 401k accounts for consumers to purchase rental real estate? For the same reason that famed criminal Willie Sutton so eloquently answered when asked to explain why he robbed banks: “Because that’s where the money is.” The bulk of Americans who have retirement savings have the bulk of those savings in retirement accounts like IRA’s or 401k’s. So when a financial intermediary is selling a product to the mass market – whether a variable annuity, a stock portfolio, or real estate – it’s often easier to sell more of that product to a retirement account because that’s where the money is.
Let’s start by explaining the key disadvantages of buying real estate in a tax deferred IRA or 401k.
1) Leverage is hard and expensive to get in a tax-deferred account
If asked the single most important key to real estate investing success, almost all successful real estate investors will cite ‘leverage’ or ‘low cost debt financing’ as the end-all, be-all answer. Generally speaking, you are taking an investment that historically appreciates by 0-3% per year and using other people’s money to increase your return on equity towards double digits. Easily the most popular form of retail real estate investment, residential properties appreciated by 0.3% per year after accounting for inflation between 1890 and 2014. 0.3% per year over 125 years does not make for an exciting investment proposition. It’s the cheap leverage that makes things interesting. The problem is that leverage is difficult and expensive to obtain inside an IRA.
Your IRA is a separate legal entity and strict laws prohibit “self-dealing” with your IRA. As a result, any borrowing inside an IRA must be in your IRA’s name, cannot have a personal guarantee, must be non-recourse, and cannot come from prohibited counter-parties like your spouse, parents, or children. These restrictions mean that IRA lenders are far more scarce. Moreover, the traditional government subsidy of mortgage loans by way of Fannie Mae and Freddie Mac backing is not available with IRA loans. Even if you can find a specialty lender willing to loan to your IRA, the financing terms will be more onerous, equity requirement will be greater, and the rate will likely be 2% more than a traditional mortgage loan.
The last nuisance with debt financing inside an IRA is that it triggers something called Unrelated Business Taxable Income, also known as UBTI. Whereas an IRA is normally a tax-exempt entity and not required to file a tax return, UBTI results in taxes for the IRA. Worse yet, UBTI taxes are assessed at the higher trust tax rates which reach a marginal rate of 37% after just $12,500 of UBTI.
The economics of real estate investing just become significantly worse when you are faced with higher borrowing costs, UBTI, and higher equity requirements.
2) No personal benefit or self-dealing
The laws against IRA self-dealing go well beyond the restriction on personally guaranteeing debt in an IRA. Want to use the beach rental property owned by your IRA for a few days? Prohibited. Pictures need to be hung, furniture moved, or ceiling lights need to be changed? You’ll have to hire someone else outside your family to do even these menial tasks. Want to let children, parents, or other family members use the property for a weekend? Again, prohibited.
So much as hammering a nail, unclogging a toilet, or changing the shower curtain in a property owned by your IRA is deemed to be self-dealing. Even personally listing your IRA-owned rental property on sites like Airbnb or VRBO is an easy-to-prove case of self-dealing for the IRS.
And don’t think that the prohibition against self dealing is something you want to risk. If the IRS discovers self dealing, the IRA is deemed to be terminated retroactive to the first day of the tax year in which the prohibited transaction occurred. You immediately owe early distribution penalties and taxes on the entire IRA balance. To be clear, this is not a friendly outcome.
Another result of the prohibition on self dealing is that you cannot personally pay the real estate tax, the insurance premium, the property manager, the landscape fees, mortgage costs, or the cost of a new A/C unit for a property owned within your IRA. Every expense that benefits the real estate owned by an IRA must be paid directly from assets within the IRA.
If your IRA does not have enough cash to cover these expenses, you can not simply contribute funds to the IRA or front these expenses from personal accounts. In such cases, option one is to quickly liquidate the property, likely at a fire sale price, while again keeping in mind that any expenses necessary to prepare the property for sale must come from the within the IRA. Option two is to go ahead and cover expenses related to the IRA-owned real estate with outside funds and face the onerous consequences resulting from IRA termination.
3) Higher Annual Expenses
IRA-owned real estate comes with all the same expenses of owning real estate plus several more that hurt the economics. One of the unexpected and non-trivial costs for IRA-owned real estate is the requirement to get the property appraised every year. In addition, you have to use a self-directed IRA administrator and they tend to charge a fee of $1,000 – $2,000/year – another expense that is completely avoidable if you’re buying real estate outside an IRA.
4) Tax Inefficient
If the abundant availability of cheap leverage is the primary advantage of real estate investing, then tax breaks are a clear number two. The US government provides all sorts of tax breaks for real estate investments including the depreciation deduction, 1031 exchange deferral, deduction of property taxes, deduction of interest expense, cost basis step-up, and the new Section 199A deduction.
All of these tax advantages are either lost or limited within a traditional IRA. Moreover, the appreciation of real estate goes from being taxed at the favorable capital gains tax rates outside an IRA to unfavorable ordinary income rates when the proceeds are eventually distributed from the IRA.
Lastly, traditional IRA owners who have reached age 70 1/2 must begin annual required distributions from the IRA. Limited cash flow in the IRA coupled with an illiquid investment can make these required distributions unwieldy.
When a Retirement Account May Be Appropriate for Real Estate
In fairness, there can be cases when an IRA or 401k may be appropriate for real estate. An investor with an outstanding real estate investment opportunity that has sizable tax deferred IRA assets but limited or no after-tax assets might be inclined to make such an investment in his or her IRA to avoid missing the unusually outstanding opportunity. It also may be advantageous to use a tax-free Roth account to make a real estate investment. All the same self-dealing risks, leverage limitations, and higher costs still hold but for real estate investments that are expected to appreciate at an unusually high rate, the economics may still work out to make using the Roth account advantageous.
Closing Comments
Tax deferred retirement accounts are great for many investments. They are, however, terrible for most direct real estate investments.
Sadly, most people fail to understand or appreciate the risks and drawbacks of owning real estate in an IRA until after the purchase has been made. And in many cases, such investors unknowingly violate the plethora of self-dealing restrictions which make for terribly onerous consequences.
For those inclined to invest in real estate, do yourself a lifetime favor and avoid using retirement funds in an IRA or 401k to make such investments.
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