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."