Tax & Business Insights

Land in 401(k) or IRA? 

Volume 19 Issue 5 --  September/October 2007

Ms. Needa Lot (hereafter, “Lot”) has $500,000 in her 401(k) and wants to buy real estate with the funds. Can she?  Possibly.  Should she?  That’s not as easy to answer. The conditional word “should” is pregnant with complications, do’s, and don’t’s. 

Many promoters of non-traditional 401(k) and IRA investments, especially on the Internet, would say that Lot not only can, but should, make this investment. In reality, the issue is more complex.

First, Lot should explore whether her employer’s 401(k) plan permits investment in real estate or self-directed accounts.  If Lot’s 401(k) master plan allows participants to make self-directed purchases of real estate or other investments (other than collectibles or life insurance), then the choices are comparable to the decisions the owner of an Individual Retirement Account (“IRA”) might make. 

Even if they are permitted, self-directed accounts (both IRA and 401(k)) present numerous hurdles that could defeat the tax-free status of the account.  Remember, the U.S. Government wants retirement funds to be used for just that purpose, retirement. 

If Lot enters into transactions which directly or indirectly benefit others sometimes described as “disqualified persons,” then there may be a “prohibited transaction.” For example, leasing the property to Lot ’s child or company would be impermissible.

Prohibited transactions typically occur in dealings with relatives and related businesses (businesses in which Lot owns a 50% or greater interest.)

Even inadvertently engaging in a prohibited transaction can lead to substantial excise taxes imposed on Lot’s account as well as loss of tax-free status for the account and early distribution penalties if Lot is not yet 59½ years of age.

As most people know, the investments of a qualified retirement plan are not subject to income taxation until the proceeds are distributed.  In many qualified plans assets double every 10 years with interest at 7.2% and no taxation. If Lot is aware of, and follows, the prohibited transaction rules, her investment in real estate could grow and not be subject to taxation until she or other beneficiaries receive the proceeds or when mandatory distributions are required. 

It would be a good idea for Lot to set aside a portion of her retirement funds in a separate account before buying real estate. By doing so, an error regarding the self-directed real estate investment will not “taint” all of Lot ’s retirement funds.

Since Lot cannot control the investments directly, it is necessary for her to use an intermediary. There are several companies in the United States that specialize in performing the custodial duties for self-directed investments from 401(k)s and IRAs.  There are of course fees charged for such services.

When it comes time to take mandatory distributions, it might also be necessary to have appraisals done on the real property every year in order to ensure that the mandatory distributions are in the correct amount.  In addition, if the investments are relatively illiquid (hard to sell), it may be difficult to obtain the cash to make mandatory distributions.

Real estate purchased in an IRA may lose some of the tax benefits of owning the real estate. For example, improved real estate can be depreciated and for state and local taxes it can be deducted, but since a retirement account is tax-exempt, there is no tax benefit from the depreciation.

Real estate not in a retirement plan, when sold, is taxed at capital gains tax rates, which currently are 15%. Gains accumulating inside an IRA or 401(k), however, will be subject to ordinary income tax rates when they are withdrawn by the retiree or the retiree’s beneficiaries. 

The choices in this area are not easy to make.  Some advisors say that self-directed accounts are an accident waiting to happen. Others, particularly those providing custodial services for such plans, argue to the contrary.  As with many choices, a lot depends on the background and ability of Lot to heed the rules that would cause disqualification for investments in nontraditional items.  If Lot makes a lot of mistakes, then her self-directed investments in real estate or whatever could be disastrous.  On the other hand, if Lot has lots of brains and pays attention to the transaction which could cause disqualification and excise taxes, she may benefit considerably from her self-directed investments.

Because there are no clear answers in this area, we have tried to be impartial. If you have  questions about this issue, other than investment-type questions, give us a call. We are not retirement plan specialists or advisors and we do not offer investment or real estate advice.

Copyright 2007
By Tax and Business Professionals, Inc.
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