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Q: My daughter is a senior in college in Waco, Texas and who has recently accepted a job in Dallas. My husband and I will be willing to help her with some of her rent because her starting salary is not that high and we want her to live in a safe area. My husband floated the idea of buying a condo or townhome and renting it to our daughter. If she has cash problems some month then our “help” would be to defer the rent. We have discussed two options — one is to get a home equity loan on our home, the other is to use my husband’s IRA. He has a SEP-IRA if that matters, but there is about $189,000 there and we think a real estate investment might be a good option for some of the money. If we could use $100,000 or so to buy the condo, and then rent it for $750 per month that would be a 9 percent return. But we don’t know if we are allowed to buy real estate in the IRA.
A: It is possible to buy real estate in an IRA, but that plan presents special problems that, in the end, don’t make sense for your objectives.
First, you will need a self-directed IRA to allow for investments in real estate. There are companies that serve as custodian for self-directed IRAs that invest in real estate, and you will probably need to roll funds from your existing account to a self-directed account.
The self-directed IRA custodian would then purchase the rental property. If real estate is acquired with debt, the IRA can become taxable on some of the income generated. This is a bad result because the funds in the IRA will also be taxed when you eventually withdraw them, so that leveraged real estate investments in an IRA can create two levels of tax.
Your plan seems to be a purchase with no debt, so you would avoid that problem. You did not state your age, but if you reach the point where required distributions must be made (age 70 1/2), it is best to have sold the real estate because distributions of fractional interests in real estate can be troublesome.
IRAs also have rules against “prohibited transactions.” An IRA is a retirement account, so your husband should not receive any benefits until he takes his retirement distributions.
A prohibited transaction could occur if your husband received some direct or indirect benefit before he takes his retirement distributions. For example, if the IRA purchased real estate you currently owned, the purchase could benefit you now.
Another prohibited transaction could be the purchase of real estate by the IRA, with your husband then living in that property, even if he pays fair rent. While that is not your plan, you do intend to rent to your child.
Rental of property to a family member is also a prohibited transaction. While you may intend to charge fair rent, this does not change the classification of the arrangement as prohibited.
So I would generally suggest that real estate rentals be held in an IRA only if the property is debt free, the rental is to an unrelated party, and there is no need to make required distributions that could include the real estate.
Your home equity loan makes more sense. It is important to charge your daughter fair rent if you want to fully benefit from the tax treatment of a rental. If she pays anything less than fair rent, including possible rent deferrals, her use will be treated as personal use by you and you will end up with a so-called “vacation home.”
Vacation home status will deny any deductions other than property taxes and interest. You should also note that items such as property taxes, insurance and association fees will reduce your calculated 9 percent return.
It sounds like your biggest objective is to help your daughter, while also looking for a reasonable investment return. A buyer’s market may allow you to meet these objectives, but don’t expect significant tax advantages.
There can also be alternative minimum tax issues that you should explore with a tax advisor familiar with your specific tax situation.
James R. Hamill is the Director of Tax Practice at Reynolds, Hix & Co. in Albuquerque. He can be reached at jimhamill@rhcocpa.com.
