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Real Estate IRA and Required Minimum Distributions

Starting at age 72, you may be required to take a minimum distribution from your real estate IRA or Solo 401(k) each year.  This concept is referred to as Required Minimum Distributions (RMDs).

If your self-directed retirement plan is invested in larger, less-liquid assets like real estate you need to ensure you will have sufficient cash liquidity to make your annual RMD.

We get a lot of phone calls and emails from investors around age 70 who are a little panicked and think they may need to sell their investments.  This is not the case.  Let’s walk through some scenarios to see how RMDs apply and how to plan accordingly.

What Plans are Subject to Required Minimum Distributions?

Many IRA and 401(k) plans are subject to Required Minimum Distributions.

Since the passage of the SECURE Act effective December 31, 2019, the starting point for RMDs is the year the account holder turns 72.

All tax-deferred IRA types are subject to RMDs.

Roth IRAs are not subject to RMDs during the original account holder’s lifetime.

401(k) and similar defined contribution retirement plans are subject to RMDs on both tax-deferred and Roth sub-accounts.

RMDs also apply to a variety of inherited IRA plans dependent on when the original account holder died and who the beneficiary is.

Read more about RMDs on the IRS website.

How do RMDs work?

When an account is subject to RMDs the end of year account value for the previous year is used.  This value is divided by a factor listed in the applicable life expectancy table provided in IRS Publication 590b.  There are table variants for different types of account holders and beneficiaries.

Younger account holders are required to distribute a smaller amount of the account.  As the account holder or beneficiary ages, a larger percentage of the account must be distributed each year.

The resulting value must be distributed from the IRA by December 31st.  Failure to take a RMD results in an excise tax of 50% of the amount that should have been distributed.

A Simple Example

Before we discuss how to plan for RMDs when your IRA is holding real estate, let’s set the table with a simple example.

An IRA valued at $100,000 value would need to distribute as follows:

Age Factor Amount Percent
Age 72 25.6 $3,906 3.9%
Age 75 22.9 $4,367 4.3%
Age 80 18.7 $5,348 5.3%
Age 85 14.8 $6,757 6.7%
Age 90 11.4 $8,772 8.7%
Age 95 8.6 $11,628 11.6%
Age 100 6.3 $15,873 15.8%

 

Of course, an IRA won’t be worth $100,000 each year over an extended period of time.  The value will change based on investment earnings and the amount distributed.

The point of this first example is just to show the basic percentage of distribution by age and how that gradually increases over time.

To lookup the RMD for your own account in a single year, you can use the following calculator provided by the SEC at Investor.gov.

SEC RMD Calculator.

This calculator only applies to an account holder whose spouse is not more than 10 years younger, or who has not named a spouse as beneficiary on the IRA.

A Real Estate Example

If your IRA holds real estate, or any illiquid asset for that matter, you need to know both the value of the account and the liquid cash value to plan for RMDs.

Your distributions need to be taken in cash.  You can’t exactly distribute the front porch of your IRA rental property to yourself while leaving the rest of the property in the IRA.

It can take a bit of guesswork to estimate how your account will perform over time and what amount of cash will be available to meet your distribution needs.

The goal of the analysis is twofold, to help you plan how much you can take in IRA distributions and predict how long your IRA can continue to hold real estate before needing to sell and reinvest in more liquid assets.

Following is an example of how this forecasting exercise works.

RMD Calculation starting at age 72

Assumptions

A Starting Property Value $200,000
B Starting Cash Value $25,000
C Net Return on Rents after expenses 5%
D Annual Appreciation / Rent Increase 3%
E Return on reinvesting cash flow in something conservative like a bond fund 2.5%

 

Income

F Annual net rents (A*C) $10,000
G Reinvestment Income (B*E) $625
H Total Income (F+G) $10,625

 

RMD

I Prior Year Value (A+B) / current year RMD factor (i.e. 25.6 @ age 72) -$8,789

 

VALUATION

J End of Year Property Value (A*(1+D)) $206,000
K End of Year Cash Value after RMD (B+H)-I $26,836
L Total Account Value, used to calculate next year RMD (I+K) $232,836
M Next Year RMD (L / 24.7 for age 73) -$9,427

 

In this first year of Required Minimum Distributions, the account still saw a net increase in value of $7,836, part of which is illiquid in the form of property and part in cash that can be reinvested or distributed.

RMDs at Age 77

If we run this scenario out 5 years to age 77, the bottom line looks like the following:

Total Income $12,363
RMD Amount -$12,390
End of Year Property Value $238,810
End of Year Cash Value after RMD $30,796
Total Account Value, used to calculate next year RMD $269,607
Next Year RMD (factor is 24.7 for age 73) -$13,281

 

The IRA is still growing in value thanks to property appreciation and the fact that net income still exceeds the RMD amount.

RMDs at Age 82

In another 5 years at age 82, things still look good.

Total Income $14,065
RMD Amount -$17,182
End of Year Property Value $276,847
End of Year Cash Value after RMD $21,912
Total Account Value, used to calculate next year RMD $298,759
Next Year RMD (factor is 17.1 for age 73) -$18,329

 

While the overall account value continues to grow, this is mostly locked up in the property which continues to appreciate.  Since the RMD amount has increased, the cash value of the account is starting to decline from its peak back at age 77.

RMDs at Age 86

Age 86 is the last year in which continuing to hold this property works.

Total Income $15,311
RMD Amount -$21,980
End of Year Property Value $311,593
End of Year Cash Value after RMD $736
Total Account Value, used to calculate next year RMD $312,330
Next Year RMD (factor is 14.1 for age 86) -$23,308

 

The account is still growing in value, but all the value is locked up in the property.  The income from the property will no longer be sufficient meet the RMD requirement.

To free up cash for future distributions, the property will need to be sold.

The property sale within the IRA is a non-taxable event.  The IRA is just exchanging $312,000 of property for $312,000 in cash.

You now have an IRA worth $87,000 more than it was 14 years earlier and can reinvest or distribute from the IRA as you see fit.

What if You Take More than the RMD?

If you choose to take more than the required minimum amount each year, this will accelerate the process.  Your IRA will reach the point at which there is no longer cash for RMDs earlier.

If you were to take an extra $5,000 in addition to the RMD each year, the cash crunch would occur at age 77 in the scenario we have outlined above.

Appreciation is, and is not, Your Friend

It is great to see the property that your IRA or Solo 401(k) is invested in increase in value.  The downside, however, is the need to take a higher cash distribution based on that value.

It is possible to see your IRA increasing in total value while at the same time getting low on liquid cash to meet your distribution needs.

Because the value of the IRA is driving a taxable event in the form of RMDs, it is important that you maintain current and accurate valuation.

Of course, when property prices go up, rents tend to go up as well.

What About Distributing the Property?

You can take a property as a distribution in-kind from you IRA.  This strategy is administratively feasible if you take the entire property out in one distribution, but that can result in a significant tax bill.

Fractional distributions of property over time are technically possible, but a very poor idea with significant costs, paperwork, and risk of IRS rules violations.  We mention this option only because you will find such a strategy written about on the internet.

Just because something is “possible” does not mean it is a good idea.

Planning Your Exit Strategy

If you can predict roughly when a property will no longer produce sufficient cash for distribution needs, you can sell on your terms.

It may make sense to sell a few years early if the real estate market where the property is located is particularly hot.  That can certainly beat being caught in a buyer’s market when you are in a position where you must sell.

You may also choose to sell before it is necessary if you know some of the major systems like roofing or HVAC may be due for repairs.  Those fixes could eat up valuable cash.

Once you sell your IRA owned property, you can reallocate that capital in ways that will better meet your cash distribution needs.

In Summary

We hope this information has helped you to think about managing your real estate IRA well into your golden years if you choose to do so.

While understanding the math surrounding your portfolio and RMDs is important, it is just a starting point.  There are many factors that go into planning for aging and ultimately the disposition of your estate.  We strongly recommend you work with licensed counsel to evaluate your specific situation.

 

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