By Dr. Jim Dahle, WCI Founder
I often see people asking about investing in real estate with their retirement account (401(k)s, IRAs, and similar) money. This is fine for publicly traded real estate (such as a REIT, like the Vanguard Real Estate Index Fund) or for debt real estate (such as a private real estate debt fund) since both are relatively liquid and quite tax-inefficient. However, I would try to avoid it for the typical equity real estate investment, whether you are investing directly or passively.
I have plenty of reasons why.
Are You an Exception?
Only two types of people should consider breaking this rule of thumb. The first is the real estate diehard, i.e. the type of person investing 50% or more of their investable assets into real estate. They love real estate, hate stocks and bonds, and always look for ways to invest more in real estate. The second is someone who has all or almost all of their investable assets in retirement accounts and still wants to invest in some type of private real estate. I’d rather see that person investing retirement account assets into equity real estate than see them missing out on the benefits of the retirement accounts entirely.
Issues with Equity Real Estate in Retirement Accounts
So, what is the problem with using retirement account money for equity real estate? There are plenty of them, but I think these are the top 10.
#1 Unavailability
The first issue is simply one of unavailability. For many people, the majority of their retirement account money is in accounts provided by their employer, such as a 401(k), 403(b), 457(b), or a defined benefit/cash balance plan. These accounts typically won’t allow you to invest in private real estate in any way, shape, or form. It just isn’t an option. Your only option is typically an IRA or an individual (solo) 401(k).
#2 Additional Fees and Hassle
Most IRA and solo 401(k) custodians don’t allow private real estate investments either. You have to get a customized, checkbook, or self-directed IRA or individual 401(k). While you can open an IRA or solo 401(k) with little hassle and minimal fees at Vanguard, Fidelity, or Schwab, you’re going to have to do something a little different if you want a self-directed account. And that’s going to cost you money and hassle. A typical self-directed IRA provider will charge you fees to open the account and to close the account. They’ll charge annual fees as well. There might be an additional annual fee for each private investment in the account. Besides the fees, you’ve added a layer of complexity to your financial life. While that is partially offset by the reduced hassle from tax preparation, it is still significant.
#3 Illiquidity
One of the biggest downsides of private equity real estate investing, whether direct or passive, is the illiquidity. Unlike publicly traded investments, you can’t cash out of these investments any time you want. Some lock up your money for five or even 10 years or return it in drips and drabs. That illiquidity does not mix well with the rules that apply to retirement accounts, much less personal needs for liquidity. For example, imagine you change jobs and want to roll your 401(k) somewhere else. Most rollovers are done with cash, and you can’t turn an illiquid investment into cash.
More information here:
Why Is There So Much Hype in Real Estate Investing?
Should You Raid Retirement to Invest in Real Estate?
#4 Required Minimum Distributions
Tax-deferred accounts require Required Minimum Distributions (RMDs) to be made starting at ages 73-75. This is a great example of a need for liquidity. Imagine you have an IRA which is entirely invested in an apartment complex. Now, you’ve turned 75 and you need to take a 4% RMD out of the account. How are you going to do that? Hopefully, the cash flow from the property will be at least 4% of the value of the account, and you can simply withdraw cash. Otherwise, you’ve got to sell off part of that property. Who wants to buy 4% of your property each year? Now, you’ve got to plan to sell that property just before you hit RMD age. And heaven forbid you die and leave this mess of an IRA to heirs. They can only stretch distributions over 10 years and often must start taking RMDs right away.
#5 401(k) Loans
You are allowed to borrow from your 401(k) in an amount up to 50% of the value of your 401(k) or $50,000, whichever is less, instead of withdrawing money from the 401(k) and paying taxes and penalties on the withdrawal. But if you’ve got your 401(k) tied up in an investment property or a syndication, you won’t have the liquidity to do that. That option is now gone.
#6 Unrelated Business Income Tax
If you invest in equity real estate in an IRA (including SEP and SIMPLE IRAs but not a 401(k)) and have a mortgage on the property, you may end up paying taxes on income from the investment. This tax is called Unrelated Business Income Tax (UBIT), and it can be a huge surprise for those who thought all income inside retirement accounts was tax-free.
More information here:
A Tale of 2 Sponsors: How My Real Estate Investments Have Had Vastly Different Results
#7 Capital Calls and Maintenance/Upgrade Costs
Many passive real estate investments call capital from time to time. But if your entire IRA is locked up in illiquid real estate investments, where is that capital going to come from? You can’t just send it in from your checking account; it has to be legally contributed to a retirement account. The likelihood that your retirement account contributions are going to be in the proper amount and at the proper time for these capital calls is exceedingly low.
Direct real estate investors have a similar problem. What happens if you need a new roof? The cash for it has to come from the retirement account. Better have something liquid in that retirement account, not just a bunch of illiquid real estate investments.
#8 Cash Drag
Real estate investments typically produce some income. That income has to stay inside the retirement account; you can’t spend it until you make a retirement account withdrawal. What are you going to do with little bits of income coming in every month or quarter? Better have a plan—such as a liquid investment paired with the illiquid one in the IRA—or it is all going to just sit in cash and often at a very unfavorable rate at your self-directed IRA custodian. The end result of capital calls/expenses and regular income is that retirement account real estate investors end up with a significant chunk of the account sitting in cash, earning a paltry rate just to avoid liquidity crunches. Better to just be in a taxable account where cash can be better utilized.
#9 Use Limitations
When you own a property in your taxable account (i.e. using non-qualified dollars), you can go down and use it sometimes. Rent out that beach property for 11 months a year and use it yourself every June. No problem. Unless it’s owned by your IRA or 401(k). That’s a big no-no. Your IRA can’t buy property from you or your family. It can’t sell it to you or your family either. You can’t even rent property owned by your retirement account.
#10 Loss of Depreciation
One of the most awesome things about investing in equity real estate is getting income that is sheltered by depreciation. If that depreciation is never recaptured, that’s tax-free income. Even if it is recaptured, it is only recaptured at a rate of up to 25%, providing significant tax rate arbitrage for high-income investors. But if your investment is in a retirement account, that depreciation doesn’t do you a lick of good. Equity real estate (done properly) is already very tax-efficient; you don’t need to put it into a retirement account. You probably have something else in your portfolio that would be better in the retirement accounts. And if a real estate investment blows up (as they do from time to time), you can deduct the loss if you’re investing with non-qualified dollars but not if you owned it in your retirement account.
More information here:
The 60+ Worst Mistakes You Can Make in Real Estate Investing
What to Do Instead
If you’re not going to invest in private equity real estate in your retirement account, what should you put in that retirement account instead?
#1 Traditional Investments
Lots of real estate investors use their non-qualified dollars for real estate and just invest their retirement account money in traditional investments, such as stock and bond index funds. Whatever their ratio of taxable to tax-protected assets is, that becomes their real estate to non-real estate assets in their portfolio. They just avoid real estate entirely in their retirement accounts.
#2 Public Real Estate
You can avoid all of the issues associated with equity real estate in retirement accounts simply by sticking with publicly traded REITs or a mutual fund or ETF that only invests in publicly traded REITs. If you must invest in real estate with your retirement accounts, this is a great option.
#3 Private Debt Funds
Private debt funds are terribly tax-inefficient. The entire return is from income, and that income is taxed at ordinary income tax rates. There is no depreciation to pass through. Retirement accounts are the best place to hold these investments. You still have an illiquidity issue, but these funds tend to be much more liquid than a comparable equity fund. They typically offer liquidity every quarter or at least every year instead of in 3-10 years. If you want to invest in private real estate in a retirement account, consider doing so on the debt side.
#4 Look for ‘1099 Funds’
Some sponsors, such as WCI sponsor MLG, offer two versions of their funds—one of which issues a K-1 and is appropriate for a taxable account and one of which issues a 1099 and is appropriate for retirement accounts and those who do not want to receive multiple state K-1s. The K-1 fund is better in taxable; the 1099 version is better in a retirement account.
#5 Borrow Money Out of Your 401(k) and Use That to Buy Real Estate
Yes, it’s only a maximum of $50,000, but that might be enough for a down payment on many properties and it can meet the minimum for lots of passive real estate investments.
Private equity real estate can cause a lot of problems in a retirement account. Try to use non-qualified money to buy it whenever possible.
If you are interested in private real estate investing opportunities, start your due diligence with those who support The White Coat Investor site:
Featured Real Estate Partners
DLP Capital
Type of Offering:
Fund
Primary Focus:
Multi-Family
Minimum Investment:
$100,000
Year Founded:
2008
CrowdStreet
Type of Offering:
Platform / REIT
Primary Focus:
Commercial
Minimum Investment:
$25,000
Year Founded:
2014
Origin Investments
Type of Offering:
Fund
Primary Focus:
Multi-Family
Minimum Investment:
$50,000
Year Founded:
2007
37th Parallel
Type of Offering:
Fund / Syndication
Primary Focus:
Multi-Family
Minimum Investment:
$50,000
Year Founded:
2008
Southern Impression Homes
Type of Offering:
Turnkey
Primary Focus:
Single Family
Minimum Investment:
$60,000
Year Founded:
2017
Wellings Capital
Type of Offering:
Fund
Primary Focus:
Self-Storage / Mobile Homes
Minimum Investment:
$50,000
Year Founded:
2014
MLG Capital
Type of Offering:
Fund
Primary Focus:
Multi-Family
Minimum Investment:
$50,000
Year Founded:
1987
Mortar Group
Type of Offering:
Syndication
Primary Focus:
Multi-Family
Minimum Investment:
$50,000
Year Founded:
2001
* Please consider this an introduction to these companies and not a recommendation. You should do your own due diligence on any investment before investing. Most of these opportunities require accredited investor status.
What do you think? Do you invest in private equity real estate? In what part of your portfolio and why? How would you invest in real estate in your retirement accounts? Comment below!
(Source)