Using Real Estate for Wealth - the Basics

Over the last three years, stocks have cratered. No-one ever told me that I was supposed to manage my retirement plan - I thought that was what the mutual fund managers were supposed to do. Unfortunately for me (and many other people) fund managers don't have a clue about creating wealth. Instead of recommending true diversification into real assets (or even the money market), they just say "buy and hold".

But one asset has skyrocketed in value during that period -- real estate.

And while your 401(k) plan may not offer real estate in any form, the fact is, you can own real estate in your retirement plans. Retirement plans are by nature long-term investments. And, you can’t get much more long term than real estate. But you must keep in mind that you’ll be able to invest only for income and appreciation. You can’t deduct depreciation, as you can in a taxable investment.

And you have to be very careful how you do it. A single bad move can create a major tax disaster. Check out your options with the tax strategist on your team.

Know the rules

The law allows your qualified plan or IRA to own just about any kind of real estate. You can invest directly in property: single family and multi-unit homes, co-ops, condos, apartment buildings, even improved or unimproved land. You can invest indirectly in real estate investment trusts (REITs), but their overheads are usually too high.

If you buy a property for your IRA, the income and appreciation normally builds up tax-free until you start to take withdrawals.

Careful now: I said normally tax-free. That’s because there’s a special tax on debt-financed income in retirement plans called the unrelated business income tax (UBIT). If the real estate is leveraged (mortgaged), then you must file Form 990-T with the IRS. It allocates the income earned between debt and non-debt financing, and the tax due. So, let’s say you want to buy a $100,000 duplex for your retirement account. You put in $70,000 and borrow the remaining $30,000. On a simplified calculation with the UBIT, you’d be able to shelter only 70% of the income. The rest of the income from the property is subject to ordinary income tax rates.

That’s why an all-cash transaction is probably the easiest.

If you don’t have sufficient cash, or you'd like to leverage your investment dollars without the dreaded UBIT, your retirement plan can purchase an undivided partial interest in a property. That’s known as a tenant in common interest. In fact, having your IRA partner with you provides the best of both worlds - you qualify for the mortgage and your IRA puts up the downpayment, and then you split the profits in proportion to the partners' investment.

Or, you can borrow the money to finance the property and pay the UBIT. Depending on aggravation level, costs, tax rates and rates of return, the leverage may be worth the tax cost.

The advantages of real estate in a retirement plan are its potential high rate of return, added diversification and its lower risk over the long run.