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George F. Bearup, J.D. Senior Legal Trust Advisor

14-Sep-21

Holding Real Estate in an IRA

Take-Away: Real estate can be held in an IRA, but navigating  the Tax Code’s self-dealing rules almost make it not worth the effort  to hold real estate in an IRA.

Background: Over the weekend I was talking with a fellow who plans to purchase a Traverse City downtown condo using his IRA. Suffice it to say that I ‘rained on his parade’ when I pointed out some of the drawbacks to holding real estate in an IRA.

Real estate can be held in an IRA, as it is not one of the prohibited assets that the Tax Code prohibits an IRA from owning. However, an IRA can hold real estate only if the IRA custodian authorizes holding real estate in the IRA, and not many do. So while  a condo,  apartment complex or a commercial building can be held in an IRA the first task will be to search for an IRA custodian that is willing to permit holding the real estate in the IRA account.

Creditors: Preferably title to the real estate will need to be held in an LLC with the LLC membership units owned by the IRA. Using an LLC will  protect, to some extent, any other non-real estate assets held in the IRA if a creditor claim surfaced with respect to the real estate, e.g. a slip and fall claim when a patron is injured on the commercial real estate.

Prohibited Transaction Limitations: Owning real estate in an IRA, however, brings the IRA owner that much closer to causing a prohibited transaction. A couple of examples of how a potential prohibited transaction violation might be triggered include:

  • A beachfront condo is held in the IRA; the IRA owner cannot vacation using the condo;
  • A commercial building is held in the IRA; the IRA owner cannot arrange to haul the trash from the commercial building;
  • An apartment complex is held in the IRA; the IRA owner cannot change a lightbulb in the hallway of the apartment building;
  • A single-family rental is held in the IRA; the IRA owner’s spouse cannot list or handle the sale of the single-family rental;
  • A commercial building is held in the IRA; the IRA owner’s son, who runs a custodial service, cannot be hired to clean the building.

As a generalization, if real estate is to be held in an IRA, it is safest if the IRA owner contracts out all the repairs, rentals, and general upkeep tasks to third parties. The cost of these services will then have to be paid from the IRA,  not the IRA owner.

The consequences of triggering a prohibited transaction with an IRA are dire. The entire IRA, not just the real estate portion of the IRA’s assets, will be deemed to be liquidated and distributed to the IRA owner. The IRA’s tax-qualified status will then be lost, and income taxes and penalties will be immediately payable on the full distribution of the IRA assets to its owner.

Practical Problems Owning Real Estate in an IRA:  Even if the prohibited transaction rules can be avoided by holding real estate in the IRA, there are also plenty of practical difficulties with owning the real estate in an IRA:

  • Liquidity:  Real estate is not liquid. When a distribution must be made to satisfy the IRA owner’s RMD obligation, a fractional portion of the real estate cannot be transferred from the IRA to satisfy the required minimum distribution to the IRA owner.
  • Valuation: If the IRA owner is age 72 or older, the owner is required to take minimum distributions from the IRA. That RMD is calculated by taking the December 31 valuation of the IRA, or all IRAs held by the owner, to determine the next calendar year’s RMD.  The IRA owner is at risk by guessing the real estate’s value as of December 31. Accordingly, usually the IRA owner will hire a real estate appraiser to value the IRA’s real estate each year that the real estate is held in the IRA subject to RMDs. This is the IRA owner’s responsibility, not the IRA custodian, to find and hire the real estate appraiser. Like the other expenses associated with the real estate, the appraiser’s fees will be paid from the IRA, not from the IRA owner.
  • Rollovers: The IRA owner cannot take the real estate out of the IRA as a rollover distribution and replace it with cash for the same value. The same property rule requires that if the IRA owner takes cash from the IRA in a 60-day rollover, cash must be returned to the IRA to avoid the early distribution rule. The same with marketable securities.  The same property rule also applies to real estate held in the IRA; the same real property must be rolled over to a new IRA, if a 60-day rollover is planned by the owner.
  • Sale of Real Estate: The real estate held in the IRA can be sold. A sale for cash is the ‘cleanest.’ More problems surface if the IRA’s sale of the real estate is financed. In that situation, there would then be a land contract or a promissory note held in the IRA, either of which, like the real estate, must be valued as of December 31 each year that asset continues to be held in the IRA. Further complications arise if the buyer then defaults on the promissory note or the land contract when it comes to valuation of a contract that is in default. Note, too, that a sale of the real estate held in the IRA to the IRA owner, the IRA owner’s spouse, or a family member of the IRA owner, will also be treated as a prohibited transaction.

Conclusion: While it is tempting to use an IRA to purchase real estate in a ‘hot’ real estate market, multiple challenges will be faced. The first challenge is to initially find an IRA custodian that is willing to hold real estate in the IRA. The next challenge will be to navigate the multiple prohibited transaction rules as they relate to maintaining the real estate in the IRA, and not jeopardize the entire tax qualified status of the IRA. Then there is the challenge when the IRA is to be rolled over to move the same real estate to the new IRA custodian. Finally, there are the practical valuation problems the real estate poses if the IRA owner is faced with the obligation to take required minimum distributions so as to avoid the 50% penalty for failing to take the required minimum distribution for the year.