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On money

Real estate is a risky path for IRAs

By HELEN HUNTLEY
Published March 5, 2006

Individual Retirement Accounts are becoming a tempting source of capital for would-be real-estate speculators. Seminars and magazine articles tout the advantages of "self-directed" IRAs that allow you to go beyond what banks and brokerages offer. Naturally, readers have questions about them.

The issue isn't whether your IRA can invest in real estate, it's how.

IRA experts warn: Watch out.

"It's legal, but Mr. and Mrs. America won't be able to follow the rules," Boston lawyer Natalie Choate said at a recent Orlando conference.

She said real estate is a fine IRA choice if takes the form of a totally hands-off investment such as a real estate investment trust, real estate mutual fund or partnership managed by a general partner. It's when investors want to be personally involved that they get into trouble, she said.

Choate and fellow IRA expert Ed Slott say these are some of things you need to know if you are thinking of investing your IRA directly in real estate:

You need a big chunk of money. You either have to pay cash or find a lender willing to loan money to your IRA without your personal guarantee, which will mean a large down payment.

You need enough extra money in your IRA to pay for repairs, taxes and other costs if a tenant moves out or your cash flow projections don't materialize. You can't contribute more than $5,000 a year ($4,000 if you're younger than 50) to your IRA and lending money to your own IRA is illegal.

You need an IRA custodian who will hold and manage the real estate for a reasonable fee. Choate says IRA custodians who offer to let you do the managing are in legally murky territory.

If you are thinking about fixing up the property yourself, be aware that your sweat equity could be considered an excess IRA contribution.

Although IRA earnings are otherwise tax deferred, the income your property earns may be classified as "unrelated business taxable income" - and if it's more than $1,000, your IRA will have to pay taxes on it.

Your property will have to be appraised annually to determine the year-end value of your account. Once required distributions begin, if you don't have other IRA assets, your IRA wil l have to issue you a deed for a fractional interest in the property each year.

Real estate offers tax advantages that don't do you any good when it's held in an IRA. Among them: Profits that would be taxed as capital gains outside an IRA become ordinary income taxed at higher rates when distributed from an IRA.

You have to be very careful not to run afoul of rules against self dealing, which means transactions cannot provide even an indirect benefit to you or your family. For example, your IRA cannot buy a building and lease it to your spouse. It cannot buy a lot in a development if you get a golf membership out of the deal.

The big risk: If you break the rules, the IRS can make your entire IRA taxable.

I am sure some readers have navigated these potential land mines successfully, but it's not the slam-dunk investment the ads would have you believe.

My daughter inherited $51,000 in a 401(k) from her father. She has received a 1099-R form for the money, less $5,000 in taxes withheld. How can we avoid paying more taxes on this money?

Some retirement plans allow beneficiaries to receive payments over a fixed period of years or over their life expectancies, but since your daughter already has taken the money as a lump sum, that's not an option.

If her father was born before Jan. 2, 1936, she is eligible for the special tax break of 10-year averaging (use Form 4972), which will reduce her taxes. If he was younger, she's out of luck.

The good news is that she will not have to pay the 10 percent penalty tax that normally applies to retirement plan withdrawals when you are younger than 591/2.

Helen Huntley writes about investing and markets for the Times. If you have a question about investments or personal finance, send it to On Money. We'll try to answer those we think are of greatest reader interest. All questions must be submitted in writing, but readers' names will not be published. Send questions to hhuntley@sptimes.com or Helen Huntley, Times, P.O. Box 1121, St. Petersburg, FL 33731.

[Last modified March 3, 2006, 19:58:03]