Building wealth through real estate has been a strategy savvy investors have used for hundreds of years. According to a Morgan Stanley study in 2014, 77% of millionaires own real estate as an investment, and ownership of both residential and commercial properties was the number one alternative investment choice among these investors. Over 30% planned to add to their real estate investment portfolio in the future.
Purchasing real estate within an IRA gives the average investor the ability to participate in the same wealth building strategies that the wealthiest investors utilize. Real estate investment opportunities are widely available.
Options within an IRA
While many Americans may not be flush with cash, many investors have IRAs, 401(k)s, or other retirement accounts that are available to fund real estate investment opportunities.
Purchasing real estate is typically done through three main channels:
- Purchasing properties with cash. When investing with an IRA, this becomes a simple cash transaction that uses the cash available within the IRA or other tax-exempt investment vehicle. For example, if the investor purchases a home for $100,000, then $100,000 is paid from the IRA, plus any closing costs or related expenses.
Cash purchases provide the investor with tax-free growth for the duration that the property is held within the account. When the money is withdrawn, the investment will be either tax-deferred or tax-free depending on the type of IRA.
The property must be owned by the IRA, which is held with a trustee or custodian, and all ongoing expenses must be paid from the IRA, with all profits being returned to the IRA, according to the IRS rules that have been established for real estate transactions.
- Purchasing properties as a percentage of ownership. This strategy requires providing some funds from your IRA and gathering funds from another investment source. The ownership of the home or property will be divided based on the percentages invested. The property will be paid for with cash.
For example, if a property is selling for $100,000 and the IRA puts in $50,000 and the other $50,000 comes from another investor, then the IRA will own 50% of the property. 50% of the expenses will be paid by the IRA and 50% of the profits are returned to the IRA. The tax-free growth will occur based on the IRA’s percentage of ownership. This enables investors to combine resources to purchase real estate, even if there is not enough in one IRA to complete the transaction without the use of debt financing.
- Purchasing properties with debt financing. Real estate property can be an expensive investment and often there is not enough cash within the IRA to purchase a property outright. Debt financing creates the ability to expand the investor’s real estate portfolio, without needing all the cash necessary for the purchase.
Debt financing, through a non-recourse loan, solves the cash problem within the IRA. This feature allows borrowers to purchase homes with a down payment and financing to cover the remainder of the costs. When debt financing is used, the record keeping must divide all income and expenses according to the percentage that is financed with the IRA and the percentage financed from the non-recourse loan. The expenses and profits will be divided proportionally between the IRA and the debt-financed percentage and all income returned to the IRA will remain tax-exempt while the income derived from the debt-financed percentage will likely be subject to unrelated business income tax.
For example, if the IRA owner buys a property for $100,000 and puts $50,000 down and finances the remainder with a non-recourse loan, the IRA owns 50% of the property and the remaining 50% is the debt-financed portion that may generate UDFI. Since the property is not solely owned by the IRA, a review must be completed each year to account for the UDFI. The profits in relation to the debt financed percentage are considered unrelated debt financed income, after expenses are deducted, and UBIT applies to this portion.
Investing in real estate with an IRA or other tax-exempt account has the potential to result in substantial gains. The ability to grow your portfolio through partnerships or debt financing can increase the portfolio size much faster than if you had to purchase the entire property with cash.