Part Two of Financing a Second Property: Self-Directed IRAs

If you cash out your retirement account in one lump sum, you stand to lose far more of your money to the IRS than you would if you took your distribution payments over time. The reason is, by cashing out the entire account, you put yourself in a much higher tax bracket for that single year since distributions from a retirement account are taxed as ordinary income. Instead of being in the 25th percent bracket consistently throughout your retirement years, for instance, you might be in a 33rd percent bracket for one year. While you don’t pay 33 percent on all that money, you may pay that rate on the lion’s share of the distribution.

The IRS has made it hard, but not impossible, to recoup some of the losses. I will be able to cushion the blow in two different ways. This post talks about the first, self-directed IRAs.

Self-Directed IRAs: A Quick View

When I told my brand-new accountant what I was about to do, he flipped out. “Do you realize what tax bracket you’ll be in?” he asked me.

He told me I should look into self-directed IRAs. This is a little known investment vehicle that allows you to invest  in “anything you like” rather than sticking to the stocks and bonds that make up most investors’ portfolios. Well, anything except collectibles, S-corp capital stock, and a short list of other prohibited investments.

You can, however, invest in real estate and land, which were the only things of interest to me.

Here’s how it works. The IRA holds the real estate through a company that acts as a custodian of the account. The big investment companies, like Vanguard and Charles Schwab, do not handle self-directed IRAs. You will have to research the companies that do handle these accounts, compare their fee schedules, and check their track records yourself.

The custodian purchases the real estate with rolled over funds from an existing IRA or 401k account after reviewing the purchase sales agreement. They then write checks to pay for ongoing property tax and maintenance and receive rental payments and other revenues on your behalf. It all stays in the IRA. The custodian files the appropriate paperwork with the IRS and charges a variety of fees to maintain your account.

You can theoretically be your own custodian by holding your investment in a so-called “checkbook” IRA as long as you adhere to the rules that govern self-directed IRAs. Checkbook IRAs purport to cut out the middleman — though even these accounts have someone who does the IRS reporting for a small annual fee. However, checkbook IRAs are hanging on to their legal status by the slender thread of one court decision, and the IRS has had its eye on them. I decided not to pursue that course.

Although the IRA shelters your money from taxes, there are a lot of rules that make self-directed IRAs a less than desirable choice for an investment property, especially if you need to pay for a lot of repairs on the property before it generates cash flow:

• You can’t work on the investment property yourself (there is some disagreement about whether individuals can perform routine maintenance such as mowing the lawn). Thus, sweat equity is out.
• You can’t live in it or even stay there one night out of the year. Nor can your parents or children live there (siblings are okay).
• You don’t get any of the tax advantages typically associated with owning an investment property.

How a Self-Directed IRA Worked for Me

Because there is an extensive list of prohibited transactions, I wouldn’t recommend that anyone use this vehicle to purchase a home they plan on living in eventually. Even if you wait until you are old enough to avoid the IRS penalty, you still have to take the entire property as a distribution (and pay taxes at a higher marginal rate). If the property appreciates enough — normally a good thing! — you could conceivably price yourself out of ever buying it from the IRS because you would not be able to afford to pay the taxes.

Because there are two houses on the lot I purchased, and I plan to keep one as a seasonal rental, I toyed with the idea of purchasing the Cabin outright and holding the Anchorage in my IRA. That would have increased my restoration budget for the Anchorage considerably and decreased my tax burden. I already had a good survey of the property, and the surveyor was willing to divide the lot on short notice so that I could make the closing date. The two houses already had separate spring houses, septic systems, electricity accounts, and insurance policies.

But the more I thought about it, the more I realized how difficult it would be to live on one house and keep the other in the IRA. It might raise flags with the IRS. More importantly, I’d never be able to host friends or family at the Anchorage, not even for a few days during the off season. And what’s the point of having a place like this if I can’t use it to host the occasional gathering?

Fortunately, the family who sold the property had already divided it into two lots; there was a 3-acre field across the street that they listed separately in order to boost interest in the place. The offer I made included both parcels, so I ended up placing the land in a self-directed IRA. Deferring the income tax on that portion of the sale reduced my tax burden considerably, and because it is undeveloped land, there is little that needs to be done in the way of maintenance, so I won’t have to make a lot of future payments into the account.

When I turn 60 I can decide whether to leave it in the IRA for my daughter to inherit or take it as a distribution then.