Real estate is a popular investment for self-directed IRA holders. Given today’s housing market, it’s easy to understand the appeal. According to the National Association of Realtors,1
- Home sales were up 12.3% over last year.
- The median existing-home sales price hit a historic high of $329,100.
- 99% of metro areas recorded year-over-year price increases for single-family homes and 89% saw double-digit price appreciation.
- Mortgage interest rates are low and there is not enough inventory to meet demand in many markets.
If your IRA is invested in residential real estate, you may be seeing growth in the value of your IRA as the strong housing market drives up property prices. But there are more ways to increase the value of a real estate investment than relying on market demand. Some IRA owners increase the value of their real estate investments by making improvements to the buildings or the land. Adding square footage to living space, upgrading fixtures and furnishings, and landscaping can all increase the value of a property. Some investors even use their IRAs to purchase and renovate fixer-upper properties and flip them for a profit as an IRA investment strategy. IRA owners who improve their real estate investments, however, must be careful to avoid engaging in a prohibited transaction with their IRA.
Paying for IRA Real Estate Expenses is Prohibited
Just as all proceeds of a sale, and growth in the value of an IRA investment, must stay within the IRA, all expenses incurred by an IRA investment must be paid by the IRA – not the IRA owner. If you’re remodeling a real estate investment, the IRA must pay the expenses for the materials, labor, permits, etc. You cannot use your own money to pay for renovations or repairs to the real estate owned by the IRA. You cannot lend money to the IRA or use your credit to obtain funds to pay the expenses. And you cannot supply the materials or the labor to perform the renovations. These are prohibited transactions under the tax laws governing IRAs.
Using non-IRA funds to pay for anything related to the real estate investment is not permitted – even for expenses that are incurred under state or other laws. For example, some self-directed IRA owners invest in residential or commercial income properties that produce rental or lease income for the IRA, such as multi-family housing and office space. As owner of the real estate, the IRA is required to ensure that general maintenance and safety measures on the property meet state and federal landlord/tenant laws. This includes paying for expenses incurred to meet those requirements such as paying for necessary repairs or maintenance and purchasing insurance.
If your IRA is invested in real estate, you might want to maintain a sufficient amount of liquid assets to cover the minimum annual maintenance, insurance, and tax expenses – and much more if you’re considering fixing and/or upgrading the real estate investment.
Prohibited Transaction Rules
The prohibited transaction rules that prevent IRA owners from independently paying expenses for an IRA investment also prohibit other transactions between the IRA owner and the IRA that would allow the IRA owner to benefit from the tax advantages of investing with an IRA while also benefiting personally outside the IRA. Examples include
- Selling property to the IRA
- Purchasing property from the IRA
- Borrowing money from or lending money to the IRA
- Providing materials or services to the IRA investment
- Transferring IRA assets or using such assets for the benefit of the IRA owner
The following individuals are also disqualified from engaging in these types of transactions with the IRA:
- IRA beneficiary
- IRA custodian or other service provider
- IRA fiduciary (e.g., investment advisor)
- IRA owner's spouse, parents, grandparents, children (and their spouses), and grandchildren (and their spouses)
- Entity (e.g., business) of which a disqualified person owns 50% or more
If you or a disqualified person engages in a prohibited transaction with your IRA, the account stops being an IRA and is treated as distributing all IRA assets at the fair market value as of the first day of the year in which the transaction occurred. If you are younger than age 59½, the taxable amount will be subject to the additional 10% early distribution tax as well.
REMEMBER – Renovations and repairs can be made to grow the value of the real estate investment in your IRA. Just remember that you can’t use your (or a disqualified person’s) money, credit, or services to fix, renovate, remodel, furnish, or maintain the investment.
Footnote
1 National Association of Realtors, accessed May 11, 2021, https://www.nar.realtor/research-and-statistics