Sweat equity in IRA real estate can be no-no

Lynn O'Shaughnessy
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Posted: Oct 17, 2006 12:00 AM

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.

You couldn't, for instance, buy a vacation home for your IRA and use it for yourself. Even if you only stayed in the residence a few days out of the year, you would be courting danger with the IRS. Your kids or your parents also couldn't hang out at the house, even if you charged them rent.

The penalty for stumbling into a prohibited transaction conjures up Old Testament retributions. Even if a mistake is unintentional, the IRA will be considered dead, dating back to the first day of the year the mistake was committed. The IRA must be dissolved, and taxes, as well a 10 percent early withdrawal penalty, if applicable, will be owed.

Here's another rule that could elicit groans. You can't boost your property's value by rolling up your sleeves and fetching your toolbox. This is what the home remodeler appeared to have done.

While you can make yearly contributions to an IRA, you can't contribute sweat equity to the property. That means you can't personally plant petunias, replace a broken window or add a deck. What the IRS will permit an investor to do is make managerial decisions. For instance, you could pick a tenant for your property and decide what rent to charge. If your tenant calls to complain about a stopped-up drain, you can decide whom to call to fix it.

Another threat that nontraditional IRA investors face is commingling outside cash with their retirement account. Suppose, for instance, that you own a condo in your IRA and your tenant's monthly rent check is late. Because of this, you won't have enough cash inside your IRA to cover the property tax. If you solve the cash flow problem by paying the property tax out of your checking account, you'd better hope the IRS doesn't notice. It could penalize you for making an excessive contribution to your IRA.

With so many ways to mess up, you have to wonder why many investors with self-directed IRAs haven't been maimed by the IRS buzz saw. But professionals I've talked to say the IRS hasn't been vigilant - at least not yet.

"At this point, the IRS is not looking," says Patrick W. Rice, the author of "IRA Wealth, Revolutionary IRA Strategies for Real Estate Investment." "At some point, though, the IRS will look hard, and if you're doing things improperly, you will get caught."