Buying Real Estate in Your IRA? Not So Fast

Buying Real Estate in Your IRA

Links Mentioned in this Episode

Complimentary Consultation   Podcast: How to Invest in Real Estate for Retirement

Dean Barber: Thanks so much for joining us on America’s Wealth Management Show. I’m your host, Dean Barber, along with Bud Kasper. 

Bud’s on Vacation

And Bud, you’re doing a little spring break time down in Florida with the family, left me in the studio all alone.

Bud Kasper: Yes.

Dean Barber: I don’t like this.

Bud Kasper: This is what they refer to as turnabout. For all the times that you’ve done this when I was in the studio and good old KC. Not today. It’s my turn.

Dean Barber: There you go. Well, hopefully, you guys are having a good time. 

Investing in Real Estate Inside Your IRA

So today, Bud, we want to talk about the idea of investing in real estate inside of an IRA. And we’re going to get to all the specifics. First of all, you can do it.

Bud Kasper: Sure.

Dean Barber: Bud, you and I have studied now with Ed Slott, and Ed is, by the way, considered one of America’s premier IRA experts, and he just wrote a rewrite of his book, The Retirement Savings Time Bomb, and How to Defuse It. He’s got a brand-new publication out on that just now. 

But Bud, in all the time that we have spent over the last, I think it’s close to 15 years now, studying with Ed. He basically says, “Why would you want to put real estate inside your IRA?? And he’s not in favor of it.

Bud Kasper: Yeah, he’s investigated it, and, as a CPA, he knows some of the pitfalls associated with paying taxes on that type of investment. Nonetheless, we all know real estate can be very fortuitous in terms of making a nice money farm in that particular investment.

Dean Barber: Yeah. First of all, let’s both get it out on the table. You and I both own investment real estate. And I think that investment real estate is proper diversification. You should have some real estate, right? 

So, there’s nothing wrong with real estate as an investment. In fact, I like it, and so do you. And I have a ton of clients that own investment properties. But they don’t own it inside of their IRA.

Bud Kasper: Exactly.

Reasons You Might Avoid Buying Real Estate in Your IRA

Dean Barber: And there are some pretty specific reasons why you don’t want to do that. Bud, it’s all about the taxes. When you have an IRA, it is a retirement account with all kinds of rules surrounding it. 

IRA Rules

It’s tax-deferred or tax-free; if you do the Roth, it’s tax-free; if you do the regular IRA, it’s tax-deferred. But on the traditional IRA, if you take money out of that IRA prior to 59 and a half, you’re subject to a 10% penalty unless you follow some very specific rules. There’s a couple of exceptions to that.

But even after retirement, as you take it out after 59 and a half, it’s subject to ordinary income tax. Well, real estate by itself can have some favorable tax treatment. You get some depreciation on that real estate to offset some of the income that it makes. 

When you sell it, you get long-term capital gains. There can be some recapture that can go back and recapture that depreciation, and that recapture can be taxed as ordinary income.

Losing Some Tax Benefits

But as of today, as we do this show, unless this new administration does something differently, when you pass the money to the next generation, the next generation gets a step-up in basis. And so they could sell the real estate with zero tax. That could never happen inside of an IRA, Bud.

Bud Kasper: You’re exactly right, Dean. And that becomes the issue. We all want to have high returns, but then again, paying Uncle Sam is the other part of the netting out of what the real profit was for us. From the perspective of what our audience might be thinking about today, you really need to know the rules, and here’s just a few.

Bud Kasper: You need to have a self-directed IRA, any real estate property you buy in your IRA must strictly be for investment purposes. You and your family cannot use it. Purchasing real estate in an IRA almost always requires paying in cash, and by the way, the expenses have to be paid by the IRA.

Paying Cash for Real Estate Purchased in an IRA

Dean Barber: Hey Bud, hold on a second. Hold on a second. Let’s attack one of those things just for a minute. I’m going to talk about the paying in cash piece. Okay.

Bud Kasper: Sure.

Dean Barber: When you buy investment real estate, the way that you can make real estate profitable is by using leverage, i.e., debt. 

A Real Estate Example

For example, you take a property that’s going to cost, to make it a simple $500,000. You’re going to put 20% down. So you put $100,000 down on that property. So now, what’s your investment in that $500,000 property? It’s a hundred thousand dollars, right? That’s your investment.

Bud Kasper: Right.

Dean Barber: Now, over time, your renters pay off that note. Once the note is paid off, you can turn that $100,000 into $500,000 or whatever the real estate has appreciated, right? That’s where you get the attractive returns in real estate. 

Buying Real Estate with Cash

If you buy real estate with cash, it’s more like you’re buying a bond, right? Because you’re just saying rent will be your income, and 5%, 6%, or 7% net of all of the expenses to keep the real estate up is a good return on real estate.

If you’re thinking about it in terms of that, you almost always have to pay cash for the real estate for purchasing inside the IRA. The reason is that you can’t have a loan on it that you personally guarantee. Otherwise, it disqualifies the IRA, makes it a prohibited transaction causing the whole thing to be taxable.

Understanding the IRA Rules 

Bud Kasper: Exactly right. That’s why you have to understand the rules before you enter into a real estate investment inside your IRA account. It can be very tricky, Dean.

The Complexities of Buying Real Estate in Your IRA

Dean Barber: Absolutely can. So my brother Shane, one of the partners here at the firm, wrote an article on buying real estate inside your IRA. When he did a Google search on real estate IRA, the day that he did, at the time he did it, there were 63,800,000 results in 0.45 seconds. So there’s a lot of people that are trying to say, this is a good idea.

Dean Barber: We’re trying to say real estate is a good idea, but be cautious and understand the complexity of the rules of putting your IRA money into real estate.

Dean Barber: Look, if you want to talk about the pros and cons of real estate, or if you want to get a second opinion from a CERTIFIED FINANCIAL PLANNER™ here at Modern Wealth Management.

Schedule a complimentary consultation by clicking here. We can visit with you by phone, virtual meeting, or we can meet with you in person, whatever you like. 

As a reminder, you can find America’s Wealth Management Show on your favorite podcast app. So you can get out there and listen to all our episodes without commercial interruption.

More Education, Means More Preparation

Dean Barber: Before we get into some details on this, we both agree that real estate can be a good investment. Of course, all investments have some sort of risk, and the question is: If you’re going to buy real estate inside your IRA, how should you do it?

Dean Barber: On The Guided Retirement Show podcast episode 23, I interviewed Dr. Randy Anderson, and we talked about investing in real estate for retirement.

I would encourage you, if you’re interested at all in understanding how to invest in real estate for retirement, to find The Guided Retirement Show on your favorite podcast app or YouTube.

Listen to episode 23, and while you’re listening, make sure you give us a thumbs up, subscribe to The Guided Retirement Show. 

The Dot Com Bubble and Real Estate in Your IRA

Dean Barber: So Bud, this idea of buying real estate in your IRA, I think, really became popular after the Dot Com Bubble. If you think about it, real estate was pretty dang boring back in the nineties, right? Nobody wanted to touch real estate because look at all the money you can make in the stock market. You had dot-com mania going on.

You had the NASDAQ doing a couple of years in a row close to 100%, all these technology funds, the technology stocks, the dot-com stocks. All that came crashing down, and we had almost three years, 2000, 2001, 2002, where we had some pretty tough times there.

With that, Bud, people started thinking, “What else can I invest in that doesn’t carry as much risk as this crazy market?” Because we hadn’t seen, then, a stock market that was that bad since the early ’70s.

The Dot Com Bubble Made it Popular

And so, that’s where this idea of buying real estate inside of your IRA started to become popular, and so they started these self-directed IRAs and saying, “Hey, you can put real estate inside your IRA.” And why did they do that? Because where do most people have most of their money? It’s in their IRAs. Okay.

Bud Kasper: They wanted the tax deferral.

Dean Barber: Yeah. That’s right. I mean, but if you look, Bud, at the typical person who comes into one of our offices and sits down, a lot of them will have some rental properties, but the vast majority of the people we talk to, most of their money is in either their 401(k) or their IRA. 

If it’s in the 401(k), it’ll eventually become an IRA. So that’s why this started to become a popular subject. I’ve always shied away from it just because of how stringent the rules are. Let’s take an example here.

An Example of Owning Real Estate in Your IRA

Let’s say that you own a rental property, your IRA owns it, and the heater goes out. So now that house needs a new heater. You can’t take your credit card and go down to Lowe’s or Home Depot or your local hardware store and buy that heater and have it put in. 

The IRA has to buy the heater, right? One transaction. If you did that and purchased the heater with funds, not inside the IRA, you’ve created a prohibited transaction, and 100% of your IRA that very day becomes taxable.

Bud Kasper: That’s right.

Dean Barber: It’s just little bitty things like that, Bud, that cause me to step back and say, “Why would I do that?”

Ed Slott’s Take

Bud Kasper: Yeah. And I think most of our audience, who’s been listening to us for years, know Ed Slott’s name and know that he is considered America’s IRA expert. He’s gone in and effectively said, “No, you shouldn’t be doing this in your IRA. It only adds to complications.”

Back to the Dot Com Discussion

I want to go back to the statement you made about the dot-com era, and I think people need to remember. Minus 46% and some change was what we lost during that particular period. And people at this point, instead of going for capital gains and growth, are saying, “Yes, I need some income off of this because I’ve made some nice money, and I want to translate that into more steady money into my pocket.”

The bond market becomes somewhat of the apparent alternative of that. If we bring this up to today with what we’re experiencing in the bond market, we’re getting higher yields. But we’re having some issues right now, as low as they are, to try to come up with something that cash flowed.

Therefore, real estate was the solution, and it could be even today in the form of REITs. This is not what we’re talking about specifically, but REITs is an investment that is essentially all real estate. We usually buy those as investors because of the amount of income and cash flow that they create. But the question is, is this the appropriate time?

Bond Yields

Dean Barber: Well, Bud, you’re cracking me up, first of all. You say we have higher bond yields, and we’re sitting, as we speak, at 1.599% on the 10-year treasury. Okay. But you make a valid point. The average investor can look at the market and say, “Man, this thing seems a little frothy.” 

You look at some of the professionals, people who know how to measure market valuations, and they’re saying, “We haven’t seen markets this overvalued since 1999, early 2000.” Okay. So we’ve got a couple of parallels. 

You’re right. The big difference today is if you go to bonds and the economy takes off, and interest rates go up, your bonds will lose money.

Bud Kasper: Yep, that was my point.

Dean Barber: So, maybe that’s why so many people today are beginning to bring up this subject of, “Should I put real estate inside of my IRA?” 

Bud Kasper: I don’t think we disagree about real estate as a viable investment for ourselves, right? But the question is, the rules many times are so strict and complicated. And by the way, in the IRAs that we use in our custodian, they won’t hold them. So you’ve got to go to a special custodian to be able to accomplish that.

Dean Barber: That’s really what this feels like to me, Bud.

 “Well, what should I put my money in? Man, if the stock market’s overvalued if we’re expecting interest rates to rise and bonds could fall, what should I invest my money in?” 

The reality is, Bud, that’s the question that everybody wants to know. And why are we talking about real estate in an IRA? Because that’s where most people’s money is. That’s where the bulk of their wealth is.

So what can I do with that wealth with an overvalued market and with the threat of rising interest rates? Well, real estate seems to be a viable option. So, how could you do it? Listen to The Guided Retirement Show episode 23, where I interviewed Dr. Randy Anderson. 

Interval Funds

He has been investing in commercial real estate for decades, and we do it with Dr. Randy Anderson, but in an interval fund.

So that interval fund is like a mutual fund. It’s a little bit different, but it can own private real estate, and it can own publicly-traded REITs, and it’s liquid. Okay. If real estate turns out to not be the place we want to be, we can sell it, and we can do something else with it.

What Does Your Money Need to Do for You?

The question that you really should be asking yourself is, “What does your money need to do for you to accomplish your short, your intermediate, and your long-term financial goals? “

You decide that, and you find that out by using our proprietary system called the Guided Retirement System™, which is designed to, at the end of everything we do, say, “Here’s your Goldilocks portfolio. This is exactly how you should invest for your goals.”

Dean Barber: While you’re here, schedule a complimentary consultation by clicking here. You can visit with us by phone, virtual meeting, or we’re happy to meet in any one of our three locations in Kansas City, either North Kansas City, Lenexa, or Lee’s Summit.

Are there Exceptions to the Cash Rule?

Dean Barber: So, Bud, you mentioned earlier that you almost always have to pay cash. Are there exceptions to that?

Bud Kasper: Not that I’m aware of. I mean, there are always exceptions, and some attorneys will figure out how to make it happen, but I’m not aware of it, Dean.

Dean Barber: Well, we know the one thing is that you can’t personally guarantee a loan on real estate held inside your IRA.

Bud Kasper: Right. I think you have to go back to the statement that you made, and that is, “Is real estate an important ingredient to my overall plan? Is it necessary for me to have the success I want?”

Dean Barber: Definitely.

Owning Real Estate is Good, But Maybe Not in Your IRA

Our listeners know already that you and I are neither in favor of buying real estate with IRA funds. We’re both in favor of owning real estate. 

We think that real estate is a good diversifier, but we believe that it’s just too complicated, and there are too many rules when it’s inside the IRA. Minor pitfalls that could trigger the entire IRA to become taxable. So that’s why we don’t recommend it.

The SECURE Act

The SECURE Act is just one more rule that I think could trip somebody up. So the SECURE Act, if you’re not familiar with what does, it requires the beneficiaries of an IRA to pull 100% of the money out of that IRA by the end of the 10th year, following the 10th year of death.

Dean Barber: So somebody passes away here in 2021. By 2031 you have to have a hundred percent of the money out of that IRA. Well, if that IRA owns real estate, what are you going to do? What if you don’t want to sell the property? What if the property is producing good income? 

Well, you could pull the real estate out of the IRA and own it outright, but if you did that, you’ve got to pay taxes, and you didn’t realize any cash to pay the taxes. So you’re going to have the money somewhere outside of the IRA to pay the tax on that real estate, or you’re going to be forced to sell the real estate, and it may not be an appropriate time to sell it. 

So again, just be cautious if you’re thinking about putting real estate inside your IRA. It might sound appealing, but if you want to own real estate, don’t do it inside your IRA.

Real Estate for Leverage

Bud Kasper: Yeah. Let me just add one final comment to that. And that is, people buy real estate for leveraging purposes. 

If you can borrow low on a piece of property that you feel for sure will appreciate over time, whatever timeframe that might be, five years, ten years, whatever the case may be, that’s one of the real advantages that real estate brings to us. And this time around not as attractive and most certainly is not attractive, in my opinion, in an IRA.

Dean Barber: Right. And if you’ve got good solid renters, the renters can pay that debt off. And so that’s where you get the multiplying effect.

Bud Kasper: That’s right. Real estate increases, somebody else is paying the bill. You’re getting a dividend provided by the people occupying your property if rental properties happen to be the type of real estate you’re investing in.

Dean Barber: But leverage can do something on the opposite side of that too, Bud. I think this is an excellent time to bring that up. So we talked about the Dot Com Bubble. We talked about the market’s going down almost 50% over a two and a half year period. 

The Great Recession

We talked about people thinking, “Okay, let’s buy some real estate, let’s put that inside our IRA.” That created a real estate bubble that burst in 2008 with the subprime crisis. I think you probably remember that, right? They called it the great recession. 

So what happened there? What happened there was too much leverage on real estate. 

A Great Recession Example

So let’s use an example. If you had a half a million-dollar property and you could buy that property and only put 5% down. So what’d you put down? $25,000. A 5% move down in the value of that real estate wipes out your entire investment, right?

Bud Kasper: Exactly. Yeah, we had one of the worst situations without a doubt that we’d ever experienced. When people were allowed to borrow money so inexpensively, that changed one of the dynamics associated with real estate. They were able to buy more home than they would’ve been able to buy if the 20% rule was still there, and that’s precisely what happened. 

You had people who had often never owned a home before buying substantial homes, and their down payment is only 6%. Sure enough, as things start to change, now they can’t keep the payments up, and now we have foreclosures, and we know it was part of the Great Recession that we experienced.

Zero Down, Interest-Only

Dean Barber: Bud, there was also the zero down interest-only loans, right? Remember, real estate was appreciating at a pretty attractive pace. And so people could put no money down, get an interest-only loan, and that interest-only loan would then balloon in five years. 

At the end of five years, people would think, “Well, now I’ll have enough equity inside of the property to refinance to a traditional 30-year fixed mortgage, and I’m going to be good.”

What happened was those balloon payments came around, and they didn’t have any equity. They were upside down. So, they were having to come to closing with a whole bunch of cash. If they didn’t have the cash, they would get foreclosed on, or they were going to have to be forced into a short sale.

Bud Kasper: Yeah. And guess what? The people that loaned them money didn’t want the property. So you had tons of properties, especially down in Arizona and Texas, that were foreclosed on and unoccupied. Of course, we had people that they were, I don’t know what the right word is, squatters inside that property, and then they endure the expense of removing them. It was a difficult period, no doubt about it.

Diversification and Market Valuations

Dean Barber: All right. So let’s end the discussion of real estate inside the IRAs, Bud. I want to switch gears, Bud, to something we talked about earlier. Diversification and market valuations. 

And you and I are both big believers in making sure that you have a diversified portfolio, but we’re both also big believers that the markets can ebb-and-flow. You can have certain sectors of the market that are outperforming or doing better than other sectors. 

You can overweight, or underweight, as it may be, overweight to the sectors that are doing better and underweight the underperforming sectors. That’s just active management and diversification.

Modern Portfolio Theory

Bud Kasper: Which was part of what was referred to as modern portfolio theory. And in the course of that, though, sometimes we get caught up in what we think are the general rules associated with investing, and then we get something that flies out of the left field, and it changes things up. 

We’re experiencing a lot of that right now with what’s happening in the bond market and the action that’s happening in technology, which had such an incredible year last year. 

They’re being challenged right now because people are starting to say, Hey, I made a lot of money in tech, and you know what? If I could hold on for that right now and put it in some fixed-income investment, or a nice dividend, or interest income on that, I’d like to do that but guess what? The rates are going up a little bit, but they’re still so darn low that it’s not an attractive investment at this point.

Where Do You Go?

Dean Barber: Right. So the question is, where do you go? And we look pretty much every day at asset class rankings. And what that is, is it just telling us which asset classes are getting the most money, and which are above average performers, which are then below-average performers. 

If we go back to July 23, 2020, what was the darling of that decade, that last decade, was large-cap stocks, Bud, and the large-cap was, even up to July 23, 2020, was doing exceptionally well, but it started to rotate. 

Diversification and Asset Allocation

So Bud, diversification and asset allocation, those things are big time in the world of financial planning. Still, you arrive at what we call the “Goldilocks portfolio” through a financial planning process that tells you how much money you should have in equities versus fixed income. 

What’s the right amount that you should have to control the risk and to achieve the return that you need to accomplish your short, intermediate, and long-term goals.

The large-cap sector of the market that has ruled the market over almost the last decade, Bud, the large-cap growth stocks have done tremendous large-cap value, large-cap blend, basically, the S&P 500 type stocks have carried the market. Still, starting in July 2020, we began to see a little bit of a rotation. 

The 60/40 Portfolio?

So the question is, if your portfolio, your “Goldilocks portfolio” says that you should have 60% equities and 40% in fixed income. Does that mean you should buy 60% of the S&P 500 index, some fund that mirrors that index, and 40% of the bond aggregate? Is that what that means. 

Bud Kasper: Well, I’ll answer it by saying yes, you could, but is that the best result you’re possibly going to get? And my answer would be, “No. I don’t think so.” 

From interviews that I did with a portfolio manager, and I’m going back almost a year now, Dean, he was completely befuddled by the fact that growth dominated the stock market’s returns for such a long time. 

Blending Investments

Now, for those not initiating what we’re talking about, you can buy growth stocks, buy value stocks, and buy a blend, which is a combination of the two. Value stocks are often the favorite way people like to invest, and the reason I say that is many dividend-paying stocks inside that type of approach to the hopeful capital game exposure. 

But value had not played as much a part in the growth of the stock market. It was the growth stocks that were dominating at that particular time. And experts in this area were, I’m going to use that word again, befuddled that we weren’t getting a rotation going back into value stocks, back in June of last year. 

I think that was your point that you made, Dean. We started to see that rotation taking place, and it most certainly continues to dominate at this time.

The Market Rotation

Dean Barber: Well, if you go to November 3, 2020, small-cap for the first time in a long time, came up to be a sector that was above average, and large-cap for the first time in a long time, went to be a sector that was below average. 

From November 3, 2020, all the way up through March 1, 2021, Bud, the IWM, which is an ETF that mirrors the small-cap blend.

Bud Kasper: Small-caps. 

Dean Barber: Yes, it was up by 41.5%, and during that same period, the S&P 500, which is your large-cap blend, was up only 16.4%. And so you have seen that rotation, and today small-cap blend, small-cap value, small-cap growth, mid-cap value, and growth. 

Those are all at the top of the charts, as far as what’s above average, and large-cap is now down to the below-average areas.

Dean Barber: So the answer to the question that I asked you earlier, Bud, is should you do 60% S&P 500 and 40% in the bond aggregate? Sometimes that’s the right place to be. 

Rebalancing and Reallocating

But if you start to see that other sectors of the market are outperforming the S&P 500, and they’re doing it in a meaningful way, and you can catch this as it’s happening, and not just wait until afterward and go, “Oh my gosh! Look what small-cap has done over the last six months. Why? Should have been there well?” 

Yeah, you should have allocated some to small-cap. You should have started to overweight a little bit 60% equity allocation doesn’t mean 60% in the S&P 500. There’s the right allocation for you. 

Now, Bud, you and I both know that when you start getting into small-caps, you’re going to have more volatility than you are in large-caps from time to time.

What is the Right Combination?

Bud Kasper: Exactly. Yeah, and this is what we referred to as diversification. I mean, in the stock market, we have small-caps, mid-caps, large-caps we value, and growth. As I said earlier, what’s the right combination? 

Well, I’ll go out on the limb and say, “You’re probably never going to get it right.” But that’s the whole point of diversification to have some of these different assets so that when one isn’t doing well, hopefully, the other one is.

Dean Barber: Well, I can tell you this the makeup of equities and the portfolios that I manage Bud today don’t look anything like the makeup of equities held in the portfolio a year ago. 

The reason is that you see a change in what’s in your favor. And it’s not that if you just stayed in the S&P 500 that you had done poorly, obviously not. But we want to maximize what we’re doing, right? 

Maximize Your Opportunities

We identify that “Goldilocks portfolio” then we can overweight a little bit to small-caps, and we can underweight in the large-caps because that’s what the indicators are telling us to do right now.

Bud Kasper: Sure. And again, as I said, it’s a diversifier. Now, a lot of people say, “Well, I’d love to get that return that I had with the small-caps, but you know what? I’ve owned those things before, and, boy, when they fall, they fall hard.” 

That would not be a misstatement. So, you’ve got to be able to measure your risk by doing what? 

Taking the total risk of the portfolio and making sure that you’re managing to that particular level of risks that you’re comfortable with as an investor.

What Should I Invest My Money In? 

Dean Barber: Well, and once again, Bud, we get the question all the time. “What should I invest my money in? Where should my money be invested right now?” 

Well, the answer to that question comes at the end of a lengthy process. That is our Guided Retirement System™, where we identify exactly what your money needs to do for you to accomplish your short, intermediate, and long-term goals. 

Once we understand what that is, we build that portfolio designed to get you where you want to go with the least amount of risk possible. And then you make adjustments along the way Bud, you’ve made adjustments to your portfolios over the last 12 months for your clients. 

Dean Barber: I’ve made them for my clients. Our other advisors have made it for their clients. So yes, we know what that “Goldilocks portfolio” looks like, but the “Goldilocks portfolio” changes with time depending upon what’s happening in the capital markets and with interest rates, political environment, geopolitical environment, et cetera.

Understand Where You Are Today 

Find out where you should invest your money by taking a test drive with our Guided Retirement System™. Schedule that here through a complimentary consultation. You pick the time you can visit with us by phone. We can do a web meeting, or we can meet in person. 

Bud’s Heading to the Theme Park

So, Bud, I know you’re excited because as soon as we wrap this up, you’re on to the theme park with the family. Are you going to get on some of those wild rides?

Bud Kasper: Absolutely. Yeah. I hope that the wind’s in my hair.

Dean Barber: There you go. Well, enjoy your time in sunny Florida, Bud. You’ve been listening to America’s Wealth Management Show. I’m Dean Barber, along with Bud Kasper. 

Remember to catch America’s Wealth Management Show on your favorite podcast app. Make sure and subscribe to it so that you can get notified every time there’s a new episode out there. We’ll be back with you next week. Same time, same place, be healthy and be safe.