It may be controversial, but more clients are doing it with advisors' help.

    Todd Terhorst, president of Diversified Wealth Management in Minneapolis, recently met with a couple in their mid-thirties who had their sights set on buying a rental property at a condominium complex in Florida, but limited access to traditional real estate financing sources. Because the couple had recently purchased a residence and had a hefty mortgage, getting another mortgage loan would be difficult, if not impossible. They couldn't borrow against their home's equity, since they had very little at that point. The couple's free cash flow was more of a trickle, and they didn't have much money in their savings accounts.

What they did have were two sizable rollover IRAs, and a strong desire to purchase the condominium. They also had on their side an IRS code that specifically bars a surprisingly small menu of investments, and a financial advisor who was willing to guide them through the transaction.

"When we laid out the options, I mentioned that it is possible to use money in an IRA to fund real estate investments," he says. "After I explained all the pros and cons, they felt it was the way to go."

Real estate is certainly not Terhort's first choice for IRA and qualified plan investing, and traditional stocks, bonds and mutual funds dominate the vast majority of his clients' portfolios. To diversify a retirement plan, he usually turns to real estate investment trusts or mutual funds that invest in them. Clients with the urge to touch and feel what they own are counseled to use money outside of their retirement accounts, if possible. After exploring all the pros and cons, "only about 2%" of his clients decide to use their IRAs to buy investment properties.

But in certain instances, such as the couple short on cash but long on their desire to fulfill their Florida dream, using IRA money may be the only alternative available. While having clients invest part of a retirement plan in real estate requires extra effort, Terhorst thinks it pays off in the long run. "I'm providing service and advice that is hard to find anywhere else, and if there are other assets to manage there's a good chance they'll use me," he says. "Besides, if they find another advisor who's willing to guide them through the transaction I'll lose the business forever."

Despite the added complexity involved, an increasing number of financial advisors are at least warming up to the notion of putting a portion of some of their clients' IRA assets in alternative investments such as real estate. Some do it to diversify portfolios beyond the traditional financial markets, which they fear will deliver modest returns in the years to come. Others, like Terhorst, see offering alternative investments as a way to distinguish themselves from the legions of financial advisors who are likely to stonewall the idea.

"People are getting tired of low stock market returns with no recourse, yet studies show that less than 2% of the population knows they can invest in real estate with an IRA," says Tom W. Anderson, President of PENSCO, a firm that administers the self-directed IRAs and other retirement plans for about 3,500 financial advisors around the country. "A lot of financial advisors don't know it either."

By law, IRAs are not allowed to invest in certain assets, including life insurance and collectibles such as art, rugs, antiques, gems and stamps. Coins are also prohibited, except for certain types of gold or silver U.S. government coins. But a surprisingly large roster of other investments are fair game, and stories of people using IRA money to purchase everything from thoroughbred horses to Dallas Cowboys season tickets have long circulated in financial service industry circles.

It may just be the latest hot trend, but Anderson says real estate is the alternative investment of choice for self-directed retirement plans. "Before the market downturn a few years ago, a lot of money in self-directed IRAs went into private equity and we got a lot of business from the dotcoms, " he observes. "Now, the main reason financial advisors set up self-directed IRAs is real estate." 

The investment may take a number of forms, including land, commercial property or a rental condominium. It may also involve a more passive form of real estate investing, such as a promissory note tied to a mortgage. Anderson says that the typical candidate for a self-directed IRA that contains real estate is someone age 40 to 65 who has accumulated substantial wealth in a retirement plan and is looking to diversify beyond traditional investments.

Bucking Traditional Wisdom

Critics argue there is no shortage of reasons for financial advisors to recommend against using IRA or qualified plan money to buy real estate. First, there's the issue of compensation. Once they provide initial guidance on how to set things up, financial advisors often have a limited role because other parties handle administration, reporting, day-to-day property management and other duties. Depending on the type of investment involved, they may also sacrifice assets under management and the fees or commissions they would otherwise see with traditional securities or mutual funds.

Broker dealers may understandably be lukewarm about advisors who put money into products they do not stock on their own shelves or perform any research or due diligence on. One advisor who has set up a number of self-directed IRAs for clients who invest in real estate says the broker-dealer firm he uses "permits but does not encourage" the practice.

There's also added complexity involved in real estate transactions. Since most boilerplate retirement plan documents from mutual funds and brokerage firms do not encompass real estate investments, financial advisors need to locate a custodian that sets up and administers self-directed IRAs and allows real estate as an investment option.

Although these custodial firms should red-flag prohibited transactions, advisors need to be aware of them as well. Among them: An IRA cannot do business with a disqualified person, such as the individual IRA owner, a spouse, parents, grandparents or children. That means a client can't buy a residence or vacation home for immediate personal use. Any rental income must first flow back to the IRA. Otherwise, it will be considered a distribution subject to taxes, and possibly penalties if it is received before age 591/2. The cost of maintaining and running the property must be paid by the IRA, so there has to be enough money available in the account for normal expenses, as well as unanticipated emergencies like a leaky roof. The property must receive an annual valuation.

Tax benefits, such as depreciation, low capital gains rates for appreciated properties and the ability to deduct losses, are lost in an IRA environment. And there's the added expense for a self-directed IRA. PENSCO charges $50 to open the account, and an asset-based fee of 10 to 40 basis points a year, depending on account size, with an annual expense cap of $1,500.

Given the added legwork and possible complications, IRA expert Ed Slott of irahelp.com says he tries to "dissuade financial advisors from investing IRA money in real estate, unless clients really know what they're doing and are not using a disproportionate amount of the retirement plan for that purpose. If something goes wrong, the blame will likely be placed on the advisor." If a client seems determined to invest in real estate with retirement plan assets, Slott recommends using a Roth rather than a traditional IRA because withdrawals receive more favorable tax treatment.

Ryan Wells, president of Wells Financial Group in Walnut Creek, Calif., has heard all about the downside of investing in real estate with retirement plan money before from local accountants who discourage the practice. Yet he points to several real estate professionals with strong local knowledge and connections who have used an IRA to fund a real estate investment in very profitable ways. "In my practice, the people who do this are in the construction or remodeling business who make improvements to a property and sell it within a short period of time," he says. As one of a limited number of professionals in his area who knows about setting up a self-directed IRA for real estate transactions, he often gets referrals from local real estate agents. He estimates that about 10% to 15% of his clients now have self-directed IRAs, and most of those contain some form of real estate.

Wells is compensated for his efforts by the fee he charges for the comprehensive financial plan as well as handling other assets the client may have under management.  But, he admits, "It's sometimes hard to convince people to diversify out of real estate once they've been successful at it."

The savvy real estate pros that Wells works with are more the exception than the rule, says Patrick Rice of IRA Resource Associates, a firm that specializes in real estate investing for self-directed retirement accounts. Most of the time people want investments that offer competitive returns without with the stresses of owning a rental property.

Among the more conservative of these options are real estate notes that banks sell on the secondary market. These notes offer the potential for a steady stream of income, as well as the ability to foreclose on the property if the borrower fails to make payments. "Most investors come to me with the intention of owning real estate," he says. "But after we discuss the responsibilities that go with owning property versus owning notes, the majority choose notes."

Despite what he considers the benefits of nontraditional IRA real estate investments, Rice, who has specialized in this area for nearly 20 years, says that working with financial advisors is a fairly new phenomenon. "I think that many of them have resisted the idea because they're more comfortable with stocks and bonds," he says. "But market forces are pushing them in another direction."