Condo Owner,
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Issues, Spring 2004



  

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Purchasing Real Estate Via an IRA: A Look at the Positives

By Alan N Potts

Editor's Note: This article is for informational purposes only. Readers are advised to discuss this information with their legal and/or tax advisor in order to gain more knowledge on this topic before making or changing any financial strategies

This article is intended to provide financial information that will assist and broaden individual retirement account (IRA) owners' knowledge in real estate and explore the opportunity of why IRA's should be used as a real estate investing tool. Many IRA owners who have experienced the painful downward spiral of their stocks and/or mutual funds now question the effectiveness of our financial markets for retirement planning. Market volatility has caused many people to extend their retirement date and question whether their money should be in the hands of money managers and sometimes self-serving corporate executives. Many IRA holders want something different, but what can they do? More than 51 percent of the millionaires in this country are self-made, and real estate was their primary investment. Each real estate investment is unique and has its own risks and rewards. The challenge in IRA/real estate planning is to understand the "relative" risks and returns of real estate compared to IRAs funded with stocks and/or mutual funds.

Exploring Real Estate Investing

There are, obviously, many different types of real estate investments, but for this article, I will discuss rental real estate.

One financial benefit of real estate ownership is the potential for appreciation or growth. Another is the ability to postpone the taxation of gains (tax deferral). That is, the tax on any appreciation is deferred until the property is actually sold. If the property is sold and the investor's property qualifies for IRS Section 1031 (tax deferred exchange), the tax deferral can be continued. If property is held for longer than 12 months and then sold, long-term capital gains rates become an attractive alternative to higher ordinary income tax rates. However, tax laws do change. Since long-term capital gains rates are currently 15 percent, some investors are opting to pay the 15 percent upon sale instead of deferring the gain and risking paying a higher tax rate in the future. If capital gains taxes are paid, the money is now theirs. This is a personal financial decision, and your tax advisor can help in this matter.

Real estate ownership can also provide their investor multi-dimensional returns. Real estate is unique from other investments; the rental income stream (cash flow) provides additional returns, and the income stream is independent of growth.

For example, if a property is purchased for $100,000 and appreciates 7 percent ($7,000) annually, this is one facet of investment return. If the investor also receives $800 in monthly rent (cash flow), the real estate is now providing multi-dimensional returns. The cash flow is received today and not deferred to some time in the unknown future.

If you calculate your total returns (growth and income), the above property would provide an annual return of 15.3 percent. Even if the growth on the real estate was overstated and is only 1 percent per year, the investor still has a fair return. If the property valued at $100,00 only grows at 1 percent per year (1,000) and receives the same monthly income stream ($800), the downside return is 10.4 percent. This is the financial power of receiving money today instead of deferring to the unknown future, Real estate gives an investor the potential and opportunity to control risks and returns.

All investments have risks and different forms of returns (income, growth, intrinsic and tax benefits). An investor must weigh all the known facets and make the investment choice.

In's and Out's of IRA's

Now, let's look at an IRA as a financial asset, one that produces one-dimensional returns and has certain financial properties other assets do not have.

In the last decade, our country's corporate management philosophy has shifted dramatically toward reducing annual dividend payouts. Corporate executives want to retain stockholder equity and re-invest potential investor dividends into corporate assets. Unfortunately, many investors have discovered another risk-- stockholder equity has been used for corporate officers personal gain. Because of these corporate scandals, many stock/mutual funds have not produced long-term growth returns.

Another expense is annual mutual fund management fees. These fees come in different forms and amounts, but the investor's average annual charge is 1 to 2 percent of the total mutual fund account balance. Because of fees, an investor should consider mutual funds as a short-term accumulation of capital savings, then shift to individual stocks for the long haul. Many financial publications and newspapers are discussing high long-term mutual fund costs and say the industry needs to be overhauled.

IRA's and other retirement plans are a unique way to save money. You defer, defer, defer and don't get to really use your money and/or enjoy it until some time in the future. This deferral theory is perpetuated because of federal and state income taxes (state specific). Most people have not been told of the distribution (taxation) problems. At retirement, IRA holders find out the tax liability becomes due. The professional recommendation of most advisors and money managers is the use of minimum/mandatory distributions and continuance of the deferral theory.

By deferring, the income tax problems are not dealt with and the investor will face the same problems again, as well as another financial dilemma--estate taxes.

In the October 2002 issue of Trusts & Estates, a journal of wealth management for estate planning professionals, Christopher R. Hoyt, a professor at the University or Missouri-Kansas City School of Law, wrote "At death, these accounts often magnify the size of the estate tax liability. Estate taxes must be paid on the entire retirement account balance, including the entire portion of the account that represents deferred income taxes. When the maximum income and estate rates reach their lowest point in 2007 (35 percent income tax rate and 45 percent estate rate), a distribution from a retirement account will be subject to a combined estate and income tax rate of more than 64 percent. In 2001, the comparable rate was more than 76 percent. These are effective rates in states that have no state income tax. An even higher rate applies to beneficiaries who live in states with a state income tax."

However, with the proposed estate tax repeal in 2010, a new financial taxation model will be created. In 1999, the last year from which the statistics are available, $23.6 billion was collected from 2 percent of decedents, with an average of more than $450,000 per taxable estate. The tax burden shift to many more Americans will be a capital gains tax on certain inherited property. Because of the shift from a marginal estate tax rate to a long-term capital gains rate, IRA's are the type of asset an IRA owner should consider using up as opposed to accumulation and passing the asset to their children and grandchildren. This issue has many subtle complexities, and a tax and legal advisor should address any concerns and questions.

In summary, IRA's are a good accumulation tool for saving but inefficient for investment and distribution. Most financial advisors still recommend defer, defer, defer. This money management philosophy generates high fees for money managers but keeps IRA holders from making other investments.

A Smart Move

What does everyone have in common? We all have a finite supply of money. Some have more than others, but we all have a limited amount. Therefore, we must watch our spending and investments. We all have investment dreams, but living expenses reduce our investment dollars and certain investments we would like to make. Is more possible?

Yes, but money management and investing should be viewed from a different financial perspective. The perception of what "you can afford" is based on the use of earned income to make investments. Since investors have the option to use their IRA as a real estate investment tool, IRA management should first be reviewed.

Instead of an IRA sitting idle (deferral), the IRA asset could be activated and used to purchase another asset, which can be real estate. In theory, the family takes this idle asset (IRA) and makes it more secure and productive because of the multiple real estate returns and benefits that become part of the total rate of return formula.

By doing this, the investor is now using the one-dimensional asset (IRA) as a financial tool to purchase a multi-dimensional asset (real estate). The investor can now pick up the potential income, growth and tax benefits associated with the purchase of the new property.

Investors must take control of their costs and risks. With less reliance on equities and institutional money managers, real estate is now used as a financial asset for retirement security.

As investors learn the economics of the transaction and see the financial results, they begin to see new possibilities they did not see before. This includes personal growth opportunities and the intrinsic returns by actually using the newly acquired properties.


  
 
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