Investors have used self-directed IRAs to invest in residential real estate for some time now. Savvy investors can also direct those funds toward commercial real estate, which typically provides higher returns and attractive tax benefits. However, a real estate purchase made through an IRA has some important differences from a regular real estate transaction. This article explores both the advantages and the risks of these investments.
Commercial real estate investments no doubt give you the comfort that comes from investing in an asset class in which you have some experience and expertise. Before you rush into such an investment, though, you need to familiarize yourself with several critical considerations.
Recognizing the Differences
A real estate purchase made through an IRA has some important differences from a regular real estate transaction — particularly the role of taxes. An IRA is a separate legal and financial entity, segregated from your personal finances. As such, it will have its own titling on legal documents related to the investments and all paperwork generally must be executed in conjunction with the account custodian, who is the signer for the account.
Note that an IRA can use a limited liability company (LLC) to own commercial real estate, but it isn’t required to do so. Investors generally use LLCs to obtain protection from personal liability — protection that’s already provided by the IRA’s status as a separate legal entity. Of course, you may have other reasons for establishing an LLC, such as checkbook control.
Targeting the Advantages
Purchasing commercial real estate through your IRA can provide a number of benefits, including significant tax advantages. Although you can’t claim depreciation on your personal tax return (because the IRA owns the property), any profits from the investment also are removed from your personal tax equation.
In addition, asset growth in IRAs is tax-deferred, so rent payments and proceeds from the sale accumulate with no capital gains tax. In the case of Roth IRAs, which are funded with after-tax money, investments are tax-free at distribution. Investments in traditional IRAs, funded with pre-tax dollars, are taxed at distribution. Roth IRAs also aren’t subject to minimum distribution requirements and their structure usually exempts the account from income taxes.
Beyond the tax implications, investing in real estate allows you to diversify your IRA holdings. Doing so also gives you the comfort of holding a tangible asset, as opposed to stocks or mutual funds.
Managing the Risks
Naturally, real estate investments aren’t without their risks. For example, they aren’t particularly liquid — especially in a down market. If you require cash to make a distribution, you could run into difficulties. The IRA will also need to have some liquidity so it can pay any expenses related to the property, such as taxes or improvements.
And don’t forget about the issue of property management. Unless you’re willing to handle those responsibilities and headaches yourself, you’ll need to hire a property manager — which is yet another expense the IRA will need to cover.
Further, if you need financing in order to buy the commercial real estate, you could end up generating unrelated business taxable income on the portion of income allocable to the financing. That income is not shielded by the IRA’s tax-exempt status.
It’s important, too, to realize some of the restrictions on real estate owned by an IRA. The property, for instance, can’t be used by the accountholder or any “disqualified parties,” including your business or family members.
Picking the Properties
If you decide to pursue IRA investments in commercial real estate, look for a property that will appreciate while providing sufficient cash flow to pay its related expenses. Ideally, the property will already have a financially reliable long-term tenant subject to a triple net lease. For help evaluating a potential property and, if desirable, establishing an IRA LLC, contact Anita Wescott at [email protected] or call her at 312.670.7444. Visit ORBA.com to learn more about our Real Estate Group.