“Imagine you could invest $100,000 in a piece of real estate today and sell it 20 years from now for nearly $400,000 without paying a dime in taxes. If you could buy that real estate with funds held in a Roth IRA, that could happen. And if the proceeds were drawn-out judiciously, you could even get the same result with funds held in a regular IRA“, says MarketWatch.com contributor Eva Rosenberg.
To buy real estate using your retirement plan, first you must set up a self-directed IRA (whether it be a traditional plan or Roth option). This may mean setting up an LLC or other entity to hold the assets. You need to find a plan administrator who allows IRA funds to purchase real estate. Make sure the administrator is there to administer the plan, not promote properties for you to buy. You also need to convince them that the property you wish to purchase is a worthy investment.
Now you need to rollover the money in your retirement funds into the new self-directed IRA. Unless there are rental properties available on the cheap, you should have a good chunk of money available ($100,000+). You’re looking for a property that appreciate in value and will generate a decent amount of cash flow.
If you don’t have enough money to buy this type of property, you may need to set up a new retirement plan that allows for more generous contribution limits than a regular IRA offers. If you are self-employed, there are two easy plans at your disposal: the SEP IRA and the Solo 401k. Both plans offer high contribution limits that will allow you to invest more in your self-directed IRA.
There is one major choice you need to make when setting up your self-directed IRA and that is whether to go with a traditional (tax-deferred) plan or a Roth (after-tax) plan. If you’re rolling over money from previous pre-tax plans, you’ll need to pay the taxes in the year you convert. You’re looking at about 35% (depending on your tax bracket) in federal taxes plus your local state taxes. If you’re just setting up a self-directed IRA in the first place, the Roth option will give you tax-free distributions when you reach retirement.
Finally, what kind of property should you buy with your new IRA? This property cannot, under any circumstances, be used by you, your close relatives and other businesses you have. This means you can’t rent out the property to your father, for example. The IRS looks at this as “self-dealing” where you receive double the benefits.
Further, you’ll have to deal with Unrelated Business Taxable Income (UBTI). If you borrow money (like a mortgage) the earning on that part of the property are no longer tax-exempt. An example from Ms. Rosenberg:
“Say you have $200,000 in your IRA. You reserve $75,000 of those funds to cover operations and contingencies. $125,000 is used as a 50% payment on the property, borrowing $125,000 as a mortgage. Suppose you collect $25,000 in rent. Half of that money, $12,500, is allocated to the mortgaged part of the property. After deducting interest and operating expenses, suppose that mortgaged half of the property shows a profit of $5,000. You will be paying taxes on those profits each year, as long as there is a mortgage.”