All our lives we, as investors, have been told to put money away for those rainy days. Today, investors are on the seemingly neverending search for solid investment ideas which produce sound returns with balanced risk. Consequently, advisors are looking for council on a lesser-known and often misunderstood category, alternative assets.
Alternative assets include a wide-ranging group, such as partnerships and private equity. But the largest segment of alternative investments has been, and continues to be, real estate; in fact, almost 60 percent of alternative asset investments are in this category. Investors can invest in condos, rental properties, raw land, commercial buildings and other types of real estate from within a Self-Directed IRA (SDIRA).
Most Americans already have real estate investments, i.e., their home, and most (given the opportunity) may prefer to invest in asset-backed investments over paper-backed investments. Many investors are wondering if today’s retreating real estate market means that the good times are over for real estate, or whether new opportunities will emerge from the wreckage. We believe that it is the latter. Real estate advisors, with whom Trust Administration Services works, suggest that falling real estate prices, combined with increasing inventory, may create new investment opportunities. As prices begin to fall back to earth, the pendulum may swing past center to create oversold conditions, providing opportunities to buy real estate at low prices. Some areas in the United States may already be starting to enter this situation. Consequently, many typical real estate investors are being squeezed out of the market due to the current credit crisis.
This has created a unique opportunity for cash-rich retirement plan investors who are in a position to purchase real estate outright. Who are these cash-rich investors? Baby boomers. 2007 marked the beginning of the wave of more than 78 million baby boomers that will begin to retire over the next two decades. This group controls more than $14 trillion in retirement plan assets, which will transition from employer-based plans to individual retirement accounts. Many baby boomers have already begun to shift away from traditional equity investments to those that generate income. When you add the factors noted above with the possibility of real estate appreciation, it is easy to see why retirement accounts that invest in real estate are growing in popularity.
Just because you can invest in real estate in your IRA does not automatically make it the best decision for all account holders. Opponents of using a self-directed IRA to invest in real estate suggest that there are specific tax implications foregone by choosing real estate as an investment. First, profits personally made in real estate, if long-term, are taxed at the capital gains rate of 15 percent. When a SDIRA sells a piece of real estate, there are no taxes due at the time of sale. However, depending on the type of SDIRA, when the owner takes a distribution from a retirement account, the proceeds will either be taxed at the person’s ordinary income rate (for a traditional SDIRA) or will, potentially, be tax-free under a Roth SDIRA.
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- This is not a loan. These tax credits do not need to be repaid
This is an important issue because ordinary income tax rates are typically higher than long-term capital gains rates. SDIRA investors cannot depreciate property or write off interest from their mortgage on their personal tax return.
In general, real estate investors experience increased return potential because of their use of leverage and its favorable tax treatment. Most real estate investment experts advocate the use of leverage to build wealth. Most SDIRAs do not use leverage to buy real estate, although it is permissible. Without the use of leverage, real estate begins to look more like income-producing bonds with equity upside. The lack of leverage may also reduce one component of risk for investors as well since the rental income is not being immediately used for debt service. If a property goes unrented the account holder owns the property outright and may not be subject to foreclosure proceedings, as with most current leveraged properties. Consequently, the methodology for buying real estate inside a tax-deferred retirement account may differ over time from real estate purchased outside the account.
Investing in real estate with an IRA requires that advisors and their clients be knowledgeable about prohibited transactions and what constitutes them. A prohibited transaction can jeopardize the tax-deferred status of the account, and can result in serious tax consequences. Another important issue for real estate concerns the access and use of property held inside the SDIRA. In such situations, neither the account holder nor their family members (ancestral & lineal) may have personal use of said property; to do so would result in an immediate prohibited transaction.
For an advisor who is seeking a niche, SDIRAs might be the answer. It takes time to develop expertise in this area, and an advisor who invests time in understanding real estate investments with SDIRAs can create a competitive advantage.
Today, many advisors are partnering with those who have alternative products in which to invest, whether they are real estate-related or other private offerings. These partnerships provide the advisor with the ability to meet the changing demands of their clients. Advisors are learning to work more closely with clients who may have a property or real estate professional already in mind. As investors’ needs change, alternative assets and self-directed retirement accounts will become important tools for advisors to help clients diversify and grow their retirement wealth. Those advisors that are prepared for this change will be at the forefront of the financial services industry for years to come.