The Challenges of Financial Planning For Retirement
The 59 million people ages 50 to 64 in 2011 will likely not have enough retirement assets to maintain their standard of living when they reach their mid-sixtiesThe Schwartz Center for Economic Policy Analysis
After retiring, how much money can I safely withdraw from my savings each year to avoid running out of money? Will this be adequate to fund a comfortable lifestyle, including unforeseen medical or other expenses?
Most Americans, whether about to retire or already in retirement, share these concerns.
Half of all individuals holding IRAs in 2011 had account balances of less than $23,800.Employee Benefit Research Institute
Until recently, conventional wisdom held that you could be reasonably certain that your nest egg would last 30 years by withdrawing no more than 4 percent per year after adjusting for inflation. According to a March 2013 article in the Wall Street Journal, even this tidy rule has been turned on its head in the aftermath of the prolonged market rout that lasted several years after it began in December 2007.
>Whether you are already retired or working toward it, asset allocation is—or should be—one of your primary investment concerns. Finding an asset mix with a predictable middle ground is particularly challenging. With money market rates and bond yields near historic lows, you risk burning through your retirement funds too quickly if you are overly invested in conservative, low yielding assets. Put too much money in the stock market, and you risk losing a portion of your nest egg.
The bottom line is that financial planning for retirement is especially difficult when forced to choose among traditional assets.
Using Real Estate to Stabilize a Retirement Portfolio
Stability and predictability are important to investors, and they become increasingly important as we approach retirement.*
Determining how to invest your retirement nest egg in order to create a reasonably sized, stable flow of income is challenging. No one can consistently predict the ups and downs of the stock market. Stable, safe alternatives such as money market funds and bonds either have very low yields, don’t protect against inflation, or both.
The benefits of individual ownership of real estate provide a viable solution to the challenges of creating stable retirement income. They include:
- Residential real estate, when properly selected for location and screened for return potential, produces stable, predictable income at rates of return several times those of other conservative investment alternatives having similar levels of risk.
- Residential real estate has built-in inflation protection: Rents typically rise with inflation.
- Over time, properly values rise. This offsets some of the effect of inflation and increases the property’s total return.
- Real estate is a separate asset class than stocks, bonds or cash. As such it provides meaningful asset diversification.
- Individual ownership provides the investor more flexibility to select real property that matches his or her investment budget and goals. REITs, Tenant in Common pools (TICs), and so forth have strict rules regarding ownership transfers and disposition. These issues are not present when you own 100% of a property.
- Unlike traditional IRA assets like stocks and funds, it is possible to leverage IRA-held real estate with a loan. In other words, you could buy a $100,000 investment property using only, for example, $30,000 from your IRA account.
In summary, any IRA holder looking to improve not only his or her overall returns, but also the stability of their investment income, should consider the benefits of including real estate in his or her portfolio.
* A Gallup Investor and Retirement Optimism survey taken in February of 2014 asked respondents to state a preference between a secure investment with a low growth potential and an investment offering high growth but with a risk of losing the initial investment. Among those not yet retired, 59 percent of those stated a preference for the secure investments, while the percentage rose to 78 among retirees.
Do Tax Laws Allow an IRA to be Used to Purchase Real Estate?
Yes. IRA funds may be used to purchase real estate, including single family homes, duplexes and other residential and commercial properties. To do so, your funds must first be held by a specialized IRA provider (custodian) that allows you to do so.
Such custodians are called self-directed IRA providers, and they allow an IRA account owner to purchase a broader range of investments, including real estate, than the traditional asset types like stocks, bonds and CDs that commercial banks and employer-sponsored IRA plans typically offer.
InvestAmarillo works with a number of firms that specializing in self-directed IRAs. We are experienced with handling real estate transactions within IRAs, and we provide expert guidance throughout the process.While we do not provide tax or investment advice, we handle IRA real estate purchases and property management for real estate held in IRAs on a regular basis. We make the process of buying and holding real estate within your IRA easy.
InvestAmarillo can help answer questions about how to hold title to the property within your IRA, and for example, who can (and cannot) live in it, who can and cannot do work on the property and how the expenses associated with the property must be paid.
It is possible to buy real estate in your IRA using a loan. Doing so requires that you obtain a “non-recourse” property loan, a specialty loan in which the lender can only look to the property itself—not to you personally—to recover any loan losses. Non-recourse loans can be a great solution should you not have sufficient cash to pay 100% for a given property or wish to put down only a portion of the purchase price for leverage.
As the market demand for real estate within IRAs has increased, a number of firms have begun offering these specialized loan products. While these non-recourse lenders typically do not make loans for non-cash producing, speculative purchases like raw land, they do offer loans for more conservative, cash flow positive properties like residential real estate.
Self-directed IRA custodians provide basic account support for their account holders, but they do not evaluate the quality of your proposed investment—hence the “self-directed” part. That’s why working with a reputable company like InvestAmarillo is critical. We make owning real property in your IRA uncomplicated and financially rewarding!
“Self-Directed” IRAs
The term “self-directed” is not a legal or IRS definition. It is a term that has come to be associated with the firms and type of accounts that they provide allowing the account holder to “self-direct” his or her investment choices. The account holder self-directs the account trustee or custodian to purchase a non-traditional investment asset such as a single family home. Examples of assets that are not permitted to be purchased with an IRA include life insurance and collectibles such as antiques, artwork, stamps, coins, alcohol, and other tangible personal property.
If the concept of buying real estate directly with your IRA is new to you, it’s not surprising: as of 2014, less than five percent of all IRA funds were used to buy real property.
Should you decide to purchase real estate with retirement funds, InvestAmarillo staff can direct you to one of several reputable IRA custodians with whom we have worked successfully in the past. These firms can explain how to open and fund a self-directed IRA with a non-taxable transfer of your existing IRA funds or other eligible retirement funds, such as a 401(k). They can acquaint you with the transactional procedures that need to be followed to comply with IRS guidelines for non-traditional IRA investments.
The Process – Buying and Holding Real Property With a Self-Directed IRA
If you are considering purchasing real estate for your IRA account, InvestAmarillo can answer any questions about the benefits or process. If this will be your first time to purchase real estate with your IRA, you should decide how much you wish to invest, then set up and fund a self-directed IRA.
As part of establishing your investment budget, you will need to determine:- How much you wish to invest– Whether you intend to pay all cash or will be financing your IRA purchase– If you will be purchasing the property by yourself or with one or more other investors, and – If you will invest directly or through a liability limiting structure such as an LLC. Since any offer to purchase real estate for your IRA will need to be made in the name of your IRA custodian for the benefit of your IRA account, you will need to have already set up and funded a self-directed IRA. You cannot buy a property in your own name then later transfer it into your IRA. Doing so would constitute a “prohibited transaction” and trigger early IRA withdrawal penalties.Once you have established your investment budget and funded your self-directed IRA account, you are ready to identify a suitable investment. InvestAmarillo maintains an inventory of investment properties on our website, including their cost, expected return and property details. When you have identified one or more of interest, contact us to get additional details on the property and/or discuss putting in a purchase offer.
After completing your purchase we will introduce you to your dedicated Owner Liaison (OL), who will explain our property management and reporting system and the issues specific to holding a property within an IRA. InvestAmarillo makes holding a property inside your IRA straightforward: We take care of routine maintenance, find suitable tenants, make repairs and report to you on a regular basis, just as we do with a non-IRA property.
Financing an IRA Purchase
IRS rules prohibit you from personally guarantying a loan on behalf of your IRA. If you decide that you would like to, or need to, put down less than the full purchase price for a property, you must use a non-recourse loan. Lenders offering non-recourse loans have special requirements regarding the kinds of properties they will and will not finance since the lender can only look to the property in the event the loan is not performing. Discuss the property you are considering purchasing with your non-recourse lender to make certain that it fits the lender’s loan criteria.
Lenders making non-recourse loans will not finance raw land, for example, since it produces no cash flow to service the loan. They also have property income thresholds, such as requiring that the net operating income exceed the debt payment on the loan by 20% or more. In short, get clarification on all the loan terms, including the amount of down payment required—typically 30% to 40%—as well as the interest rate and loan amortization period.
There are unique pros and cons when using a non-recourse loan in connection with an IRA property purchase. In the plus column, a loan provides leverage and will allow you to purchase a property costing more than twice as much as the money you have allocated for a real estate purchase in your self-directed IRA.
The income generated by an IRA property that has been financed will be allocated between a taxable and non-taxable portion in the same proportion as the loan to down payment percentage. This impacts the way in which you account for your income since the income allocated to the portion of the property financed by the loan is taxable as Unrelated Business Income Tax based on the loan producing Unrelated Debt Financed Income (UDFI). These topics are covered in IRS Publication 598.
There is nothing wrong or improper about generating unrelated business income, so you shouldn’t avoid using a loan with your IRA real estate purchase for this reason alone. As part of your initial research, speak with your accountant and/or attorney to better understand how a loan will impact both your return on investment and your taxes.
Frequently Asked Questions – IRAs and Real Estate Investing
The term “self-directed” is neither a legal term nor an IRS definition. It refers to an IRA holder (investor) being able to “self-direct” his or her IRA account trustee or custodian to purchase a non-traditional asset such as real estate. This means that the IRA holder, rather than the custodial firm, is responsible for selecting the investment and performing the necessary due diligence.
In a typical IRA account, the account holder chooses among a list of traditional assets offered by the IRA custodian, including stocks, bonds, ETFs (exchange-traded funds) or mutual and money market funds. There is no legal or regulatory difference in an entity that offers IRAs versus “self-directed” IRAs. Entities that offer “self-directed” IRAs just offer their customers the ability to purchase additional types of assets (non-traditional ones).
Assets that are permitted to be purchased in an (self-directed) IRA include:
- Real estate, including residential or commercial properties and raw land
- Tax lien certificates, tax deeds, real estate notes and real estate options
- Precious metals (bullion in bars or coins)
- Private equity (investing in private companies)
- Private loans (making loa ns to a third party)
- Other – Examples: Race horses, truck fleets, cotton or alternative investment funds
Prohibited asset types include investments in life insurance, collectibles, alcoholic beverages and tangible personal property. Examples of collectibles and therefore assets not permitted to be purchased with an IRA include stamps, (collectable) coins, rugs, artwork and antiques.
Prohibited transactions are those that IRS regulations specifically prohibit as an improper use of an IRA account by the account owner, the account owner’s beneficiary or other disqualified persons. These rules are primarily designed to prevent self-dealing or conflict of interest transactions that directly or indirectly benefit the IRA account holder or a disqualified person rather than benefitting the IRA itself.Some example of prohibited transactions include borrowing money from it, selling your own property to it, receiving compensation for managing the account and/or real estate held in it, personally guaranteeing a loan for an IRA and buying property for personal use (e.g., office, home, vacation home or rental to a family member).
Examples of disqualified persons are the IRA holder and members of the IRA holder’s family, including spouse, ancestors, children and any spouses of children, plus any corporation, partnership, estate or trust in which the IRA holder has a 50% or greater interest. The IRA trustee or custodian is also a disqualified person.
Yes, but you must use a non-recourse loan rather than a traditional loan in which the lender can look to you for recovery in the event the loan is not repaid. There are unique pros and cons when using a non-recourse loan, and the income generated by the property will be allocated between the non-taxable portion paid for with IRA funds and the taxable portion supported through the loan. See Financing an IRA Purchase.
Yes. You may purchase property directly with non-disqualified family, friends or other investors. You may also form, for example, an LLC that will purchase the property and have the parties buy a portion of the LLC. You should consult an attorney and CPA knowledgeable in IRAs to make sure that both the tran saction and the ownership structure are permissible. For example, if you were to partner with a family member to purchase a property he or she already owns, this would constitute a prohibited transaction.
No. You may not perform
any work on a property owned by your IRA. This would constitute a prohibited transaction.
Yes, by taking a 100 percent distribution in kind of the real estate—once you are allowed to take distributions from your IRA. The type of IRA (traditional or Roth), age and tax bracket of the account holder and length of time the asset was held will determine what taxes, if any, will be due by taking the distribution in kind.
An LLC is most often used in connection with two potential benefits. It is used to provide its members with limited liability protection, and it can reduce the administration fees charged by the trustee/custodian and the associated paperwork for the account holder.
In the case of real estate purchases, an LLC would allow the profits to flow through to the member(s) while also offering protection from tenant or worker liability claims. Since an LLC is a legal entity separate from the IRA holder, the IRA holder can manage the LLC and execute transactions directly—such as paying utility or repair bills—without involving the IRA custodian. This reduces the account holder’s administration time and expenses since the account holder would otherwise have to fill out an expense reimbursement request, submit it to the custodian and also pay a fee for this service. As with any other issues regarding your potential IRA investment and how best to structure it, check with your lawyer and CPA.
The risks of purchasing real estate do not fundamentally change whether the property is purchased with IRA or non-IRA funds. Interest rates, rental demand, property valuations and the other factors potentially impacting the return of an investment are not impacted by the source of the funds used to purchase it. In practice there are differences, some of which increase risk and some of which decrease it.
Many IRA purchasers of real property pay in cash from their accounts. By doing so, you lower the investment risk up front since there is no loan payment to make. If rents were to drop significantly, you could still be cash flow positive when leveraged investors are squeezed trying to service their loans. Of course this is not due to the fact that you used IRA money—the same would be true if you purchased a property with cash using non IRA funds—but this is a consequence of the majority of IRA properties being purchased all cash.
If you were to make a property purchase and leave insufficient reserve funds in your IRA account, you could experience difficulties if you were to have a large, unexpected cost or repair since you cannot use non-IRA funds to pay the expenses.
InvestAmarillo understands IRA property purchases. We have the experience to help make purchasing and holding an IRA property as simple as possible for our investors.
