depressed man counting pennies from retirement fund

Using real estate investments in your individual retirement account (IRA) is an attractive option for many investors. It can yield a greater return than traditional stocks and bonds, not to mention it’s a great way to diversify your portfolio. Plus, real estate is considered an inflation hedge, so you can generally expect it to increase (or at least retain) its value over time. But aside from these benefits, maintaining nontraditional investments in an IRA requires skill, and unless you know what you’re doing, you could fall victim to a few pitfalls.

Prohibited Transactions

Your personal money and the funds of your IRA need to be separate to avoid disqualifying your entire account. For example, let’s say you purchase a gallon of interior paint on your personal credit card to spruce up your rental property before a showing. When the bill arrives at the end of the month, you use money from your IRA account to pay the balance on your credit card. This is a prohibited transaction and invalidates the full value of your IRA, not just the $35 you spent on paint. Other prohibited transactions include living in the rental property, renting to family members, and using the property as collateral for a mortgage.

Tip: Before you make any financial purchases with your IRA, it’s a good idea to consult a tax advisor so you don’t engage in a prohibited transaction.

High Custodian Fees

Real estate is deemed a nontraditional holding, so banks and brokerages can’t help you when it comes to setting up these investments. As an investor, you’ll have to go through a custodian who knows the rental property laws and regulations, which (of course) isn’t free. Generally, the custodian manages all financial transactions on your property, but this professional can also help you with other aspects of your account, such as tax support and account administration. Ranging from hundreds of dollars to a couple thousand, custodial fees tend to vary and depend largely on the amount of assets in your IRA account as well as the type of services provided by your custodian.

Tip: To avoid expensive custodian fees and gain full control over your retirement plan, you can become your own broker by investing in a self-directed IRA account.

Greater Tax Liability for Losses

In normal investment property scenarios, you pay a lower tax rate (i.e. capital gains rate) if you sell at a profit, and if things go awry you can simply write-off your losses. But real estate IRAs are different. These assets cannot be written-off—in fact, they’re subject to ordinary income tax rates, which are higher than long-term capital gains rates. Also, once you’re age 70.5 or older, you’ll have to start withdrawing a certain amount from your IRA, and unless you have enough assets in your account to cover the distribution, you may be forced to sell the property.

Tip: Consult with an experienced tax advisor for best practices before you take an IRA distribution.

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