Lynn O'Shaughnessy

A year ago, a popular financial magazine featured a story about an enterprising fellow who purchased a fixer-upper and then sold the house for a quick profit after remodeling it. The story would have been unremarkable except for a couple of important details.

The money for this real estate deal was plucked from the man's Individual Retirement Account. While few people realize it, using retirement cash to buy a house, a condo, a parking lot or even a Laundromat is completely legitimate. But what even fewer investors seem to realize is that investing in real estate inside an IRA can transform the retirement account into a Molotov cocktail.

I don't know what happened to the ambitious investor, but he may have spent face time with an IRS auditor. What possible transgressions could this guy have committed? Well, if our fix-it man had, for example, plastered a wall, nailed a few boards or replaced dingy linoleum tile in the kitchen himself, he potentially would owe the IRS a harrowing amount of taxes and penalties.

I bring this anecdote up because the number of people who are toying with the idea of investing in real estate within their IRA has been growing. Experts in the field suggest that roughly 2 percent of the $3.6 trillion to $3.8 trillion IRA market is now in real estate and other nontraditional investments. Real estate became an irresistible alternative to some investors as their exasperation with the markets, beginning with the tech implosion, grew more and more unbearable.

The IRS has indirectly encouraged this growth by allowing taxpayers to throw their retirement cash into just about anything inside their so-called self-directed IRAs. It only prohibits IRA investments in S corporation stock, life insurance, loans to the IRA owner, and collectibles, such as artwork, antique furniture and stamps. That leaves a lot of creative wiggle room for people who are disenchanted with stocks, bonds, mutual funds and certificates of deposit. Intrepid investors have gambled their retirement assets on overseas real estate, trust deeds and private equity, as well as more oddball investments, such as fishing rights in Alaska, boat slips, earth-moving equipment, a locomotive and tree farms.

While owning an apple orchard inside your IRA might sound like fun, following the IRS's playbook could be more exhausting than pruning every last tree.

One formidable roadblock that adventuresome investors can smack into is what's called a prohibited transaction, which the IRS considers to be any improper use of an IRA by the owner or other so-called disqualified persons, which include spouses, parents and children.

Lynn O'Shaughnessy

Lynn O'Shaughnessy is the author of Retirement Bible.

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