At Safeguard, we often hear the question, “Can my IRA purchase a property today that I can then use personally in the future?”

Yes, this can be done. But does it make sense?

Below we take a deeper look at the plusses and minuses of this strategy.

Rules…Rules…Rules

With a self-directed IRA or Solo 401(k), there is a tremendous amount of flexibility to invest in a wide range of opportunities such as real estate, venture capital, and more.

However, it’s important to keep in mind that the tax-sheltered status of a retirement plan comes with certain IRS restrictions — namely, keeping everything at arm’s length, and ensuring that all plan activities are for the exclusive benefit of the plan.

You can’t personally benefit from your retirement plan directly. Your only benefit is growing the value of the plan so you’ll have suitable savings to enjoy your lifestyle in your golden years.

While an asset is in your plan, you may not use it personally in any way. Likewise, you can’t transact with your plan.

This means there is no way that you can purchase an asset from your plan in the future. This prohibition holds true whether the purchase is direct between you and the plan, or in some indirect fashion like selling an asset from the plan to a 3rd party, then personally purchasing the asset from that person.

The only way you can extract an asset such as a property from your plan is to take the asset as a distribution from the plan in-kind.

The In-Kind Distribution Process

Once you reach normal retirement age of 59½, you have the option of taking distributions from your retirement plan without a penalty for early distribution. Prior to this age, you can expect a 10% penalty for any distribution, which usually makes for bad financial outcomes.

When taking a distribution, you can do so in cash, or distribute an asset in-kind from the plan to yourself. The in-kind distribution process starts with having the asset formally valued. For real estate, this would mean getting a licensed appraisal.

Other assets may be valued in different ways, such as the current exchange listed price for cryptocurrencies or commodities, the open principal balance on a mortgage note, etc. With any asset in-kind distribution, having a rock-solid certifiable value is critical in case the IRS ever decides to challenge that value.

Once the asset has been valued, it can then be transferred out of the IRA to you personally. This will require updating the ownership documents such as a deed to property.

With an IRA-LLC, the path of title takes two steps: from the LLC out to the IRA account itself, then from the IRA to the account holder.

With a Solo 401(K) title only needs to be updated once, from the plan to the account holder.

The end result of the process is that you now hold the asset personally and the value of the asset has been distributed from the plan. The plan value is reduced accordingly.

Tax Implications

In a tax-deferred IRA or Solo 401(k), the amount you distribute from the plan is considered income to you. Any such distribution income is added to your other income for the year.

Your combined total income will then determine your tax bracket. Real property is generally a pretty big-ticket item. Taking a distribution of a lump sum of $100K, $200K, or more in one year can put you in a high tax bracket, potentially in the 32% to 37% range.

Ouch!

The taxes owed will need to be paid from savings outside the retirement plan. In order to pay taxes from the plan, you would need to distribute a larger amount, pay taxes on the cash portion, then use that post-tax remaining cash to pay taxes on the property distribution. The math will not be in your favor.

In a Roth IRA, the distribution is tax-free if qualified, which generally means after the age of 59 ½. As such, a distribution from a Roth IRA can be less painful.

However, the opportunity cost is still quite high, as you are removing a large amount of value from the Roth IRA and eliminating the potential to create more tax-free income with future plan investments.

What About Partial Distributions Over Time?

In order to soften the blow of distribution taxes, some investors consider a series of fractional distributions over time. There are some strategies that are technically possible but practically infeasible, and this falls into that category.

Say you wanted to stretch a distribution of a property over a 4-year period. At the first step, you would have the property appraised, then distribute 25% of the value to yourself. The property would need to be re-titled to be held jointly 75% by the IRA and 25% by you.

All expenses and income for the following year would then be split on that 75/25 basis. Operating a property in this fashion introduces risk, as any deviation from the proportional split could be viewed by the IRS as self-dealing and result in disqualification of the entire IRA.

At the end of the first year, the property would need to be appraised again. You would then take a distribution in an amount that results in the IRA and you personally each holding 50% of the current market value.

For the following year, you would split expenses 50/50 with the plan. This process is repeated each year until the full value of the property has been distributed. You may not personally use the property until it has been fully distributed from the IRA to you.

The cost of appraisals and re-titling of the property combined with the complexities of joint-venture ownership between yourself and the IRA make this an expensive and difficult work-around. In many cases, it may be simpler and more cost effective to just take the property out of the IRA all at once.

An Example

Let’s look at an example to see how an in-kind distribution of property might look.

John’s family vacationed at Ocean Beach every summer when he was growing up. The tradition and memories had a strong pull for him.

One year, while vacationing there with his own family as an adult, John saw a property for sale and fell in love. The idea of being able to have his own place from which to watch the waves roll in and serve as a base for crabbing and bonfire adventures filled John with joy.

But, having a family to support in the city and a daughter in college is expensive. A $300K 2nd home was just not going to be feasible.

John has $450K in an old 401(k), as well as $100K in the retirement plan with his current employer. Taking $300K from the IRA to buy the property doesn’t seem so bad, as it would still leave a good bit of conventional retirement savings in place.

John and his wife figure they can rent the property out for several years, then in 7 years when he reaches age 59 ½, they can take the property out of the IRA and be able to use it personally.

If the property appreciates at 3% annually, then in 7 years it will be worth about $369K.
If John and his wife are still working and have their normal adjusted gross income of $160K per year, adding $369K of taxable income will put them in the 35% tax bracket. Their tax bill will be about $136,500, of which $110K is a result of the property distribution.

The end result is that they spent $300K of John’s IRA plus $110K in taxes to obtain a property worth $369K. The nearly $70K gain in equity in the property ended up costing them money instead of building their savings.

The blow is softened somewhat by the fact that the property produced about $20K per year in net rental income to the IRA, growing the IRA value by $140K. The problem is that John needed to take a distribution of the majority of that IRA growth in order to pay the large tax bill associated with the property distribution.

A Better Plan

The tax hit of taking a large lump sum out of your IRA all at once is the deal killer in this scenario.

In the end, you are not receiving any of the tax-sheltering benefit of the IRA on the gain in value of the property and are needing to give up non-plan savings or take an additional distribution from the plan to absorb the tax hit.

Let’s look at a smarter plan.

Maybe the house at Ocean Beach is a good investment. $20K net cash flow per year and 3% appreciation is nothing to sneeze at. That is the real analysis one needs to make when putting an IRA into real estate.

What is the ROI, and is it better than other investments the IRA could be making today? Maybe the better investment is a $300K 4-plex in suburban Chicago.

It may not have the emotional appeal of the beach but might produce better cash flow. Maybe a limited partnership interest in a mortgage note fund that produces 11% annualized return is better than any rental property?

If John’s ultimate goal is to be able to afford that beach house in Ocean Beach, the best way to get there is to focus on getting the safest, most reliable return for the IRA over the next 7 years.

When John reaches age 59 ½, he can then sell whatever asset the IRA has invested in. If we stick with the beach house, that means his IRA that was originally worth $300K will now be worth $509K based on the cash flow over 7 years and appreciation in the property value.

The IRA will not pay any taxes on the sale of the property, so the investment gains are fully tax-sheltered. John has grown his IRA by 69%!

And look, the property right next door to the IRA’s former rental is for sale, at the same market value of $369K.

John can then take a $92K distribution from his IRA in order to make a 25% down payment on that other property not owned by his IRA. This will add about $20K to his tax bill for the year, which will total out at $49K instead of the $136,500 in the prior example.

And there is still $417K in the IRA that John can reinvest in something else like another rental property, some mortgage notes, or even just a conventional portfolio of equities and funds.

In fact, John would not even have to sell the original property. The earnings it has generated over the years will exceed the $92K he needs to buy the property he wants for personal use.

Each year going forward, John can take a smaller distribution of about $18,000 to pay the mortgage on the beach property. That is much more manageable from a tax perspective.

In certain cases depending on use, John may even get the mortgage interest deduction on that 2nd home at the beach. It should be obvious that the financial outcome is much better in with this approach.

ROI is Priority #1

When it comes to investing in alternative assets such as real estate with a self-directed IRA, only one thing matters…getting the best mix of risk/reward for the IRA and growing the IRA most effectively over time.

Using an IRA to accomplish something you wish to do personally is generally going to be self-defeating because of the high cost of exit. You can certainly use a self-directed IRA to achieve your personal goals, but doing so directly with the IRA is not the right approach.

Rather, focus on growing the IRA with the best possible investments. Having a bigger IRA when you get to your retirement years will allow you to live your dream.

Purchasing foreign real estate with your IRA plan can have similar rules and considerations. While there are plenty of opportunities for profit in foreign countries, there are some complexities that you should fully understand before using your IRA funds on a beachfront property in a tropical paradise »