Purchasing Real Estate
In A Self Directed IRA or Qualified Pension Plan
By Maurice Glazer
In today’s downsized, recessioned world, we’re all looking for creative ways to protect, diversify, and grow our assets. One way to buy a property – either at home or abroad – that you may not have considered is through a tax-deferred account. This can be an IRA (Individual Retirement Account) or a Qualified Retirement Plan (Defined Contribution/Defined Benefit Plan). Using a tax-deferred account won’t suit everyone’s needs – but is it fits yours, it provides another way you can diversify your retirement portfolio.
There are restrictions on how you can use these tax-deferred vehicles, of course. There are also pros and cons to each vehicle. But both let you buy property now using tax-deferred retirement funds… allowing you to pay tax later, when you begin disbursing funds from your retirement account.
Maximize your tax-deferred income
This example shows how you can maximize your tax-deferred income by setting up a small corporation.
Jane Doe, 55, runs a Bed & Breakfast out of her large, rambling home. She recently incorporated her business, which earns about $50,000 a year, and set up a 401(k) plan for it. Jane is the sole participant in the 401(k).
Business operating expenses run $14,000 a year. That leaves $36,000. Of this, her company puts $6,000 in the 401(k) as a profit-sharing contribution, and Jane takes a salary of $30,000. She puts $15,500 of the salary in the 401(k) as deferred income and pays personal income tax on the rest ($14,500).
Jane therefore has added $21,500 to her 401(k) in just one year (the $15,500 deferred income plus the $6,000 in profit sharing). Before incorporating her business, she could only contribute a maximum of $5,000 a year into an IRA.
Using an IRA to buy real estate
Pension plans have always invested in real estate, of course. But what we’re talking about here is your ability to buy a specific property and have full control over how you manage it. The first step is to transfer your IRA funds into a type of account called a Self-Directed IRA. A Self-Directed IRA is just what its name suggests: an IRA for which you make the investment decisions.
You’ll need to pay a set-up fee to create the Self-Directed IRA. These fees vary depending on the institution you choose, but can be as much as several thousand dollars. There may also be on-going fees. You may not find the fees listed on the institution’s website, so be sure to ask about fees before you set up the account.
An attractive alternative to Self-Directed IRAs
An alternative to a Self-Directed IRA is to set up a small business and create a retirement plan for it (like a 401(k)). These retirement plans are known as Defined Contribution (DC) or Defined Benefit (DB) plans. You’ll need to set one up that permits investment in real estate. But as it’s your company, you – as trustee of the plan – have control over how the plan funds are invested.
Defined Contribution/Defined Benefit plans offer the following advantages over Self-Directed IRAs:
- Set-up fees and management costs tend to be much lower.
- You can put more money in the retirement plan each year – up to $200,000 a year (see how this works in the sidebar Maximize your tax-deferred income).
There are many types of “small business” you can set up that qualify. For instance, if you do any sort of independent work, such as consulting, or if you’re an artist or a freelance writer, you can incorporate yourself as a business and then set up a retirement plan for that business. (In fact, anyone who has to fill out a Schedule C for U.S. federal income tax can do this.) Other options include setting up a partnership, or setting up another kind of small business.
The small-business option, as opposed to a Self-Directed IRA, works well for:
- Those who already have a small business, or who have a freelance, money-making activity that they can incorporate as a business.
- Those who have a business activity that they want to do in Mexico sometime in the future, and who can formally set up that business now. (Real estate management or sales, and mortgage brokering are common choices among those moving abroad.)
You can roll into your small business’s retirement plan any traditional IRA, and rollover SEP IRA funds you have as well as any previous employer retirement funds – that is, 401(k) funds. In addition, you can put into it any on-going Defined Benefit/Defined Contribution funds from your business.
Provided you’ve set it up correctly, you can use either of these vehicles – a Self-Directed IRA or a Defined Benefit/Defined Contribution plan – to invest in real estate in Mexico or anywhere else. And – just as with any other investment in a tax-deferred portfolio – any capital gains are tax-deferred too. They’re then taxed at ordinary income tax rates when distribution occurs.
Caution: Set up a real business
Here are a couple of key caveats about setting up a small business with its own retirement account:
- Some people have set up a business, created a retirement account for it, rolled their IRA and 401(k) funds into this new retirement account – then used those funds to cover start-up costs for the new business. This is a no-no. The U.S. Internal Revenue Service considers this a disbursement of tax-deferred funds. It will tax you on these monies, and – depending on your age – you may also have to pay penalties for early withdrawal. So be sure to use your retirement funds for investment.
- Setting up a company with a retirement plan just so you can buy your Mexico real estate with tax-deferred funds will also raise red flags with the IRS. It’s okay to set up a business that has zero income for a while – for instance, if you form a company this year for an activity you plan to start doing in Mexico next year – but you’d better have a business plan and some “reality” to the business.
Key points to keep in mind
There are some key differences between how you buy and hold real estate in a tax-deferred retirement plan, and how you do it using regular after-tax income. These will affect how you’re able to use your property.
If you buy through a tax-deferred retirement plan:
- You buy the property in the name of the retirement plan (either a Self-Directed IRA or a Defined Benefit/Defined Contribution plan). Your name appears on the deed – but as trustee or custodian of the retirement plan.
- You’ll need to get an appraisal of the real estate’s value each year.
- You must pay for any on-going costs related to the property out of funds in the retirement plan – not from regular income.
- If you use the property to generate rental income, you will need to pay tax on the net rental income. It’s called Unrelated Business Income Tax (UBIT), and you’ll pay it annually.
- You can’t live in the property or stay in it for vacations – it’s investment only. If you want to take a vacation, stay someplace else.
- If you need to take out a loan to supplement your retirement plan’s funds in order to buy the property, you’ll have to meet a series of requirements. For instance, your credit can’t be used to facilitate the loan; you’ll have to make loan payments out of a retirement plan, not with regular income; and if you’ve bought the property through a Self-Directed IRA, the loan monies will be subject to tax. There are more requirements as well.
These are just some of the most notable differences. Talk with an experienced tax accountant if you’re interested in buying real estate with retirement plan funds. He or she can help you understand the requirements for both Self-Directed IRAs and Defined Contribution/Defined Benefit plans. Walk through the pros and cons for each option, and see which best suits your situation.
Maurice Glazer is CEO of Glazer Financial Network. You can contact him at firstname.lastname@example.org.