No Personal Use
This is a thorny question, because there are lots of restrictions around this sort of purchase with an IRA account. First of all, you need to understand that you cannot use the real estate personally, if it is owned by your IRA. Specifically, you, your spouse, heirs, and any other linear relatives can not use such a piece of real estate while your IRA owns it. That factor in itself should answer the question for a lot of folks.
So, for example you could not – purchase a home in a sunny clime and use it for your own purposes two months out of the year (allowing your family members to stay there, in addition to your own two weeks during the winter, for example) and then rent it out the rest of the year. The IRS disallows such use, and will consider your real estate investment to have been distributed, and therefore fully taxable as ordinary income.
On the other hand, if you owned such a home and rented it out for a profit, this could still be owned by your IRA.
Additional Issues
If you’re still reading, you must be determined to try this anyhow, so here are some additional issues that you need to deal with… If you use a mortgage (actually a special type of mortgage called a non-recourse loan) to purchase the property, regardless of how it is used, the income from the property will be considered Unrelated Business Taxable Income (UBTI) and therefore taxable in the current year. This particular wrinkle has caused many IRA real estate investors to lose the qualification on their money and owe tax on the entire account.
In addition to the UBTI issue, there are more restrictions: you cannot provide services to your IRA, such as sweat equity in fixing up the old fixer-upper or managing the property yourself (you would have to use a third-party manager); you also cannot sell a piece of property that you own to your IRA (or purchase it from a relative); any income from the property must be deposited in the IRA account, and all expenses associated with the property must be paid by the IRA account. If your IRA account doesn’t have enough cash on hand to pay insurance and property taxes, for example, you might have to either sell the property or distribute it to yourself in order to make sure those payments are made – otherwise if you paid the expense yourself the IRA could become immediately taxable to you.
Distribution
Lastly, as you decide that you’re going to now occupy the home, you have to distribute the property from the IRA – making the entire then-current value of the home subject to ordinary income tax. So if you purchased a home in a depressed area (think Florida coast, for example) at $100,000, and then five years later when you want to move into the home when it is valued at $200,000 – you have to pay ordinary income tax on the entire $200,000 in one year. If you had very little other income for the year, the ordinary income tax (federal only) would amount to $56,000 (using 2010 tax rates).
Bottom Line
If there is a piece of property that you could not otherwise purchase, using IRA funds might not be a bad way to go. I would suggest a couple of things though: 1) you should purchase the property outright if you can, to avoid the whole UBTI issue; 2) you should plan your income in the year of distribution, so that you limit the ordinary income tax hit; 3) hire an experienced “Self-Directed IRA” trustee to help you through the process. Because this process can be so very complicated and fraught with error, it will pay off for you to get someone on your side that has handled these transactions successfully in the past.
However, in my opinion, using the IRA to own property that you eventually will occupy is an enormous headache that you could probably do without. If you really want to own real estate in your IRA as an investment, look at rental property or commercial property – perhaps in a REIT. Owning real estate outside an IRA is a big enough headache, and when you add all of the additional restrictions to the process, I can’t imagine that it would be worthwhile.
Here’s a better idea: wait until you’re ready to retire, then find that property that you want, and use distributions from your IRA to fund a mortgage on the property (or if you really want to, distribute the funds and buy it outright without a loan). You’ll have far less headaches, and the outcome will be very similar. Good luck!
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