Learn the advantages of funding individual retirement accounts with commercial property.
Purchasing residential property using retirement funds
has received a lot of press, but what's still new to many investors is the fact
that commercial real estate also can be bought this way. In fact, the
Internal Revenue Service allows individual retirement accounts to hold all types of commercial real estate including offices, restaurants, strip malls, warehouses, and
parking garages. Commercial real estate professionals can provide some useful
background information if clients are curious about purchasing real estate with
Using IRA money to fund commercial real estate
investments has specific advantages not available to investors purchasing
property in more traditional ways. For example, IRAs offer income tax
deductions for contributions and deferred taxation of gains and appreciation.
Furthermore, IRAs may be partially protected from creditors' claims under state
laws. This level of protection varies greatly from state to state and depends
on a number of factors including the IRA type and the creditors'
Certain IRS restrictions and limitations apply to IRA
money used for commercial property purchases. For example, the IRS prohibits
certain transactions, including owners leasing properties to their own
businesses and selling properties that they currently own to their plans. IRA
plans that engage in such prohibited transactions will lose their tax-protected
status. In addition, properties must be for investment purposes only and cannot
be used or leased by investor/owners or their family members. Internal Revenue
Code Section 4975 provides an overview of prohibited transactions. Review the
requirements online at www.fourmilab.ch/ustax/www/t26-D-43-4975.html.
Another consideration for financed properties is that
mortgage interest is not deductible for IRA-owned real estate. Also, if the
income stream requires payment of unrelated business taxable income, the trust
tax rate may be higher than the individual rate. Per IRS regulations, IRAs are
required to be held in trust for the exclusive benefit of the account owner and
his or her beneficiaries. IRAs are established at trust companies, banks, or
other qualified financial institutions and formally titled in the institution's
name for the benefit of the client. In this instance, real estate is no
different than any other asset within the account.
Potential investors should consider several factors to
determine if investing in real estate through an IRA is a good strategy. Two
questions that investors should consider are diversification beyond what a
traditional portfolio provides and the risk and management requirements of
alternative retirement plan investments.
If an investor
determines that commercial real estate investment within an IRA is a good
option, the first step is to open a self-directed IRA with a custodian who is
well versed in alternative investments such as real estate. A custodian can be
a trust company or other qualified financial institution that holds stock
certificates and other assets, such as the title to a real estate purchase, on
behalf of a corporation or individual. A financial adviser can assist investors
in finding custodians that specialize in specific asset types. Questions to ask
when selecting a custodian include:
• Does the custodian have a specialized background in
administering IRAs that hold real estate?
• Is there an experienced service team that can walk the
client through the process?
• Does the custodian also hold traditional investments so
all the client's IRA assets can be held with one company?
Upon locating an experienced custodian, investors should
consider financing options. Three main financing options are available to
investors who want to purchase commercial real estate within IRAs.
Individual ownership. In this structure, the entire
property is purchased using only an investor's IRA funds. This scenario
requires substantial IRA savings; however, this may become more common as
retirement plans grow.
Multiple ownership. More than one IRA investor can pool
funds to purchase property. Multiple ownership structures include tenancy-in-common,
limited liability corporations, and private real estate investment trusts.
In most instances, all expenses must be paid with IRA
funds based on the plan's pro rata share of expenses. For example, investor A
and investor B want to purchase a $100,000 commercial property. Sixty percent
of the purchase price, or $60,000, comes from investor A's private funds and 40
percent, or $40,000, comes from investor B's self-directed IRA. Because the IRA
owns 40 percent of the property, the IRS requires that 40 percent of the
expenses for purchasing, holding, and selling the property must be paid with
the investor's IRA monies. For that reason, some custodians require investors
to maintain minimum cash balances in their accounts. If investor B directly pays
for an expense, the IRA could face severe consequences ranging from a 6 percent
excise tax to disqualification. In addition, 40 percent of any income and sale
proceeds derived from the property are deposited directly into investor B's
Financing the purchase. Investors can obtain financing to
purchase commercial real estate properties with IRA funds through either
institutional or private lenders in the form of non-recourse loans. If the
borrower defaults under this structure, the lender may take the property but
cannot pursue the IRA or the individual account owner.
Regarding distributions, real estate is handled the same
as any other asset in a retirement plan. Per IRS rules, investors can begin
taking distributions from IRAs at age 59 1/2 and are required to begin taking
minimum distributions at age 70 1/2.
The amount of the required minimum distribution is based
on a number of factors including the account's value. When the investor decides
to take the property as a distribution, the property is re-titled in the
investor's name and the amount of the distribution is determined by the
property's value. For example, an investor is holding a commercial building
valued at $500,000 in an IRA account. When the investor is ready to take the
property as a distribution, the property is re-titled in the investor's name
and the account shows that a distribution to the account owner was made in the
amount of $500,000.
It also is possible for the investor to take a fraction
of the property as a distribution. Using the example above, if the investor
wanted to take 50 percent of the property's value, or $250,000, as a
distribution, the property is re-titled to show that the investor owns 50
percent of the property and the IRA owns 50 percent.
Real estate transactions in IRAs are very detailed.
However, well-informed investors looking to diversify their IRAs may find that
investing in commercial real estate is a viable option. All investors should
consult qualified financial, tax, and legal consultants when considering these