Tax season is over and after a few days of recharging, most accountants are now back at work on returns that were extended. One thing that struck me the past few months is the number of questions I’ve received about self-directed IRAs and investment in real estate by Individual Retirement Accounts.
I take this as a sign that people are beginning to think more positively about real estate as an investment and/or they are wary of the stock market and are looking for alternatives to their portfolio.
IRAs certainly can invest in real estate, in closely held business entities, and in private loans. They can include any other investment that is not specifically prohibited by law. The question I was asked dealt with real estate.
Although these investments are allowed, not all trustees are set up or willing to act as a custodian for this type of asset. There are companies out there that specialize in handling real estate investments for you and many will provide some literature on the workings of such structures. But they will not provide ongoing guidance, since this may be construed as giving legal and tax advice. Thus, custodians of these IRAs often leave investors on their own when it comes to compliance and tax issues. That is why it is important to work with an attorney and an accountant who are familiar with the rules.
Certain legal and tax issues can cause potential problems with such investments. First of all, not all activity within an IRA is free from tax. Income from rental property is normally free of tax. Income from debt-financed property, however, can create a tax burden within the IRA. This is true whether the property is held directly, or indirectly through an LLC. The IRA, in this case, may be required to file a Form 990-T and pay income tax. These taxes can be onerous because IRAs are taxed at trust rates. So, for example, for 2013 the net income over $11,950 is taxed at a hefty 39.6 percent.
Other questions can arise, too. For example: What happens if the IRA needs more capital because of major repairs on the property or some other big cash outlay? What happens when the IRA’s owner has to begin taking required minimum distributions but all his or her IRA is tied up in real estate? How is the value of the investment determined for purposes of calculating the required minimum distribution?
These issues, along with prohibited transactions (which are too numerous to be discussed here), can create potential pitfalls. That’s why it is critical that investors work with qualified attorneys and accountants in setting up this type of structure.
My goal is to give my clients and the public useful information, explained in plain English, about their finances and taxes. If you have a question you’d like me to answer in a future article, please let me know.
Randy McIntyre is a Certified Public Accountant and a partner in McIntyre, Paradis, Wood & Company, CPAs. He has worked in public accounting since 1977, in Wilmington since 1992. His firm is built on a history of service, technical expertise, and innovative to provide the expertise of larger firms with a personal, one-on-one approach. To learn more about McIntyre, Paradis, Wood & Company, see www.mpwcpas.com. He can be reached at [email protected] or 910-793-1181.
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