Problems with Real Estate in Tax-Favored Retirement Accounts

In yesterday’s post I mentioned some types of investments that create legal problems when housed in a tax-favored retirement account. Today I focus on everybody’s favorite investment: real estate. Well, maybe not this year’s favorite. Anyway, there is no per se prohibition against real estate in a tax-favored retirement account. But there are so many traps to avoid, it becomes a real practical difficulty. Here’s some.

The Trustee. It can be difficult to find an IRA trustee or custodian willing to hold administratively difficult assets like real estate. What about 401(k) trustees? Forget about it. Not gonna’ happen.

Valuation. Tax rules require that retirement accounts be valued once a year, generally on December 31. Unlike publicly traded stocks, bonds, and mutual funds, it’s difficult to value real estate. You can't just look up the fair market value of a house on the pages of the Wall Street Journal.

Carrying Costs. Real estate tends to have high carrying costs—real estate taxes, maintenance expenses, mortgage payments, and the like. Even if you personally have the funds to afford these payments, you may not be allowed to get the dollars into the retirement account where they’re needed, due to legal restrictions on contributions, as described in February 4’s post.

Distribution. Retirement accounts are subject to required minimum distribution rules, requiring distribution of relatively small amounts each year. But real estate tends to have a relatively high value. You can’t easily distribute it in small dribs and drabs. It’s all or nothing.

Illiquidity. You can end-run the distribution problems described in the last paragraph by having your account sell the real estate, but real estate is illiquid. You can’t just snap your fingers and cause a sale like you can with stocks, bonds, and mutual funds.

Financing. Financing a real estate mortgage in an IRA creates Unrelated Business Taxable Income, requiring the IRA to pay a tax, obtain its own taxpayer ID number and file a tax return—which is all quite burdensome for an account that is usually tax-exempt and burden-free.

Prohibited Transaction Potential. There are oodles of hidden highly-penalized prohibited transactions waiting to bite you unexpectedly when you have real estate in an IRA. Here are some examples:

• Your IRA rents a vacation property to your children? Prohibited transaction!
• You spend a weekend at your IRA’s vacation property? Prohibited transaction!
• Lend your IRA money to pay the real estate tax bill (with or without interest)? Prohibited transaction!
• Personally enter into a contract to buy a property which is then closed by your IRA? Prohibited transaction!
• Co-purchase the real estate 50%-50% between you and your IRA? Prohibited transaction!
• Distribute a fractional interest in the real estate to yourself to meet the IRA’s required minimum distribution obligation? Prohibited transaction!
• Personally guaranty the IRA’s real estate mortgage? Prohibited transaction!
• The list goes on. It's a minefield out there.
  

Bottom line? Better to own your real estate outside your retirement accounts.