Financing Focus

IRA Investments

Learn the advantages of funding individual retirement accounts with commercial property.

By Joan Owens |

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 IRA money.

IRA Advantages

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' aggressiveness.

Important Considerations

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.

First Steps

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?

Financing Options

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 IRA.

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.

Managing Distributions

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 transactions.