In order to invest money from a traditional or Roth IRA in rental property, you must first set up a self-directed IRA. Some companies, such as
You'll need a significant amount of money in your IRA because you'll probably want to pay cash for your rental property. If you borrow to finance the property, you'll run into the unrelated business taxable income (UBTI) rule, which could require you to pay hefty taxes on your rental income and profits when you sell inside the IRA, says
In addition, you must pay others to do work on the property, using funds from the IRA, even if you're capable of doing the work yourself. Run afoul of these rules and your IRA could be disqualified, triggering taxes and early-withdrawal penalties (if you're younger than 59½) on the entire amount.
Landlords typically enjoy a host of tax write-offs for depreciation, property taxes and other expenses. When you own the property in an IRA, however, you can't claim any of those tax breaks. Worse, if you own the property in a traditional IRA, profits will be taxed at your ordinary income tax rate, not the more favorable capital-gains rates. (If you own the property in a Roth, it isn't an issue because gains are tax-free.)
Finally, if you own the property in a traditional IRA, you'll encounter major hassles when the time comes to take required minimum distributions. Once you turn 70½, you must take annual withdrawals from all of your tax-deferred accounts, based on the year-end balance of your IRAs. To determine the year-end value of a piece of real estate, you must obtain an appraisal, says David Mendels, a CFP in
Appraisals are expensive--the average cost is about
A better choice. There are other ways to invest in real estate in your IRA that won't jeopardize your account's tax-advantaged status. One good option is a real estate investment trust. REITs own property such as apartment buildings, offices, malls, warehouses and hotels. They're required to return at least 90% of taxable income to shareholders, so dividends are typically generous. REIT stocks yield 3.9%, on average, compared with 2.1% for the S&P 500.
If you'd rather invest through a mutual fund, you have plenty of choices. Kiplinger's top picks include Manning & Napier Real Estate S (symbol MNREX) and
Because dividends are always taxed as ordinary income, IRAs provide a tax-efficient way to invest in REITs. In a traditional IRA, taxes on the dividends will be deferred until you take withdrawals. If your REITs are in a Roth, dividends--along with all other earnings--are tax-free.
Sandra Block is a senior associate editor for Kiplinger's Personal Finance. .