Purchasing a vacation home with your IRA/401k plan

Summer vacations are the perfect time to find a dream home in the perfect location. Today’s investors sometimes need clever solutions for affordability, so it’s important to be aware of all of the available investment tools. One such tool is the self-directed IRA. Did you know that your IRA/401k funds can be used to buy real estate? Let’s look at some of the options available for purchasing a second home with IRA funds:

1.    Vacation home is purchased and held in a self-directed IRA for investment purposes only.

This scenario is the simplest. Existing IRA or 401k funds are used to fund the investment account. The IRA directly owns the property and receives special tax treatment by the IRS.

PROS:  If you love this home and this area, chances are others will too. Vacation homes in desirable locations can be valuable investments. The property may be rented out to vacationers and earned income grows tax-deferred or tax free in the IRA. Many investors also enjoy holding hard assets like real estate in addition to or instead of paper assets as part of their portfolio.

CONS:  You cannot personally use any real estate owned by your IRA account. This second home would be purely for investment purposes. The IRA must pay all expenses associated with the vacation home.

IMPORTANT CONSIDERATIONS:
Compare the return on investment for the vacation home, whether from rental or resale to the return on investments currently held by your retirement account. If cashflow and/or returns on the vacation home are higher, it is probably worth looking at the investment as a potential option for your IRA/401k plan. 

2.    Buy the property now and plan to live there after you retire.

Up to age 59 ½ this option would work identically to Option 1 above. At age 59 ½ you can elect to take a percentage (up to 100%) of ownership in the IRA-owned property in lieu of cash distributions from the IRA. Once you have distributed 100% ownership, you are permitted to use the property as a vacation or primary home.

PROS: Purchasing the property now protects your ability to own the property at retirement. As real estate in popular resort areas continues to rapidly rise, you will have locked in your price at today’s cost.

CONS:  This strategy requires patience. You cannot personally use the property until you have distributed 100% ownership after age 59 ½.

IMPORTANT CONSIDERATIONS:
Taking the property distributions can take time. Talk with your advisors and make sure that you are willing to wait the necessary time.


3.    Secure a mortgage using your IRA and make mortgage payments via IRA distributions using the 72t exemption, which eliminates the 10% early withdrawl penalty.

This scenario is the most complex and will require consulting with a team of professionals to execute properly.  Essentially, the IRA invests in an annuity or other investment with guaranteed payments or stable cashflow.  As money flows into the IRA account from the annuity or other investment, payments are received as a distribution (without penalty) by the IRA holder. These distributions are used to pay the mortgage on the second home, which is held directly by the individual, NOT by the IRA account. Contact our office for a follow-up consult or for a report on 72t exemptions or visit 72t.NewDirectionIRA.com

PROS: You can begin using the property immediately as it is owned directly by you. This strategy provides investment capital for investors with IRA balances that are larger than personal cash savings.

CONS: Investor must be 59 ½ or older in order to take advantage of a 72t exemption. Since the property is owned directly by you and not the IRA, you lose all of the tax advantages of IRA-owned properties.  As a result, taxes apply to the sale of the property as well as the rental income. Income tax is paid on the distributions used to pay the property mortgage.

IMPORTANT CONSIDERATIONS:
You must already have enough wealth to create the annuity providing guaranteed payouts substantial enough to pay the property mortgage.

Buying property using an IRA/401k not only provides critical investment capital, it also has associated tax advantages.

Living in your IRA-owned real estate

“I have an IRA invested in Real Estate. Now how do I take that real estate to live in, when I’m retired?”

Hopefully, that rental property has served your retirement plan well, not only appreciating in value over time, but also providing regular monthly cash flows over a number of years.

But what if you’ve decided you really want to retire and live in that house?

If the house was purchased by your Roth IRA, and you’ve held the Roth IRA for 5 years and turned 59 ½, it’s yours to distribute to yourself, with no tax or penalties.

But what are your options if your real estate assets were held in a Traditional account?

Certainly, you can distribute the house once you’re 59 ½, without paying any premature withdrawal penalties. But you’ll have to pay taxes on the dollar amount (in this case, property value) of your withdrawal, as though that amount was some cash added to your income in the year you take it. Naturally, since we’re talking about thousands of dollars, this may be costly. However, you have a few options:

1) You can distribute your IRA’s holdings a little bit at a time.

For example, at age 59 ½, you could begin distributing 10% of the property from your IRA each year. If you distributed 10% in year one of such a program, this would result in the property being owned 90% by your IRA and now 10% share is owned by you. You’ll need to arrange with the title company so that the ownership share is properly reflected accordingly each year. You’ll still be constrained from using the property personally until it is entirely distributed from the IRA. This will allow you to spread the tax burden from distributions over a 10-year period.

Keep in mind, this will change your monthly cash flows. You will personally be entitled to a direct 10% of income and responsible for 10% of expenses. These proportions would need to be honored since there are now two investors: you and your IRA.

2) You could consider converting a portion of your IRA (including that real estate asset) to a Roth IRA.

Yes, you’ll pay income tax on the amount you convert, but this may make sense for you, if you anticipate a number of years more of income to sock away, and for your IRA’s value to grow, before reaching age 59 ½. The point here is you may be paying some tax now on a smaller amount, instead of paying tax on a potentially larger amount down the road at retirement.

You could also convert a fractional share from your IRA to a Roth IRA each year so that at some point in the future your Roth IRA owns the entire property. Then, if you’ve reached age 59 ½ with 5 years in that Roth IRA, it’s available to withdraw free from penalty or tax.

3) You may elect to begin distributing shares of your property before retirement age by using the 72T method.

The IRS grants the 72T method (substantially equal payments) as an exception, which enables one to avoid the penalty for early IRA withdrawals.

The 72T exception offers a choice of methods, which you can use to tailor the timeline of your distributions. All are based on your life expectancy (or, if you elect, on the joint life expectancy of you and your beneficiary), and whichever method you choose must be continued for at least 5 years or until reaching age 59 1/2.