Alex Finkelstein is co-editor of Debt & Equity Journal, from which this article is excerpted.

Boston—A growing number of investors are using self-directed, tax-deferred individual retirement accounts to own commercial real estate, according to mortgage bankers and real estate tax lawyers interviewed by DEJ.

Both John Edwards, a director in Arbor Commercial Mortgage's Boston office, and Terence J. Delahunty, a real estate practice partner in the Orlando, FL office of Foley & Lardner, say many investors are using the cash values of tax deferred accounts as a source of equity for acquisitions. However, Charles J. Beaudrot Jr. and Scot Burton, both of the real estate capital markets group of Atlanta-based Morris, Manning & Martin LLP, say the pros of using an IRA account to acquire real estate may be outweighed by the cons.

"As a rule of thumb, it is often a bad idea," Beaudrot says. However, he continues, "There is no simple answer. It depends on the individual taxpayer's asset mix, both inside and outside the IRA." Section 408 of the Internal Revenue Code permits individuals to purchase commercial and residential property, land, condominiums, trust deeds or real estate contracts with funds held in a traditional IRA, Roth IRA or SEP-IRA.

"In theory, you can invest in real estate using your IRA funds," Delahunty explains. "In practice, however, doing it can be challenging, especially to those unfamiliar with real estate transactions." He says the biggest risk is investing too much of the IRA in real estate, with little or no diversification left in the portfolio, adding: "The landscape is littered with disillusioned investors who had little or no knowledge of real estate investing before they put their dollars into properties."

Still, Delahunty says a cash-loaded IRA may be a good candidate if an investor uses it to buy property on an unleveraged basis because it would avoid the unrelated business income tax (UBIT) problem for mortgaged real estate. UBIT rules apply to income of non-profit entities, including IRAs, whose activities are unrelated to their exempt purpose, Delahunty notes. "A portion of the income from the real estate investment may be UBIT if the property is subject to mortgage debt," he adds. On the downside, however, Delahunty says using all cash forfeits the opportunity to leverage an acquisition and defeats the traditional methods of building wealth with borrowed funds.

"A better vehicle for buying real estate with IRA funds might be a Roth IRA instead of a traditional IRA," Delahunty says. That is because proceeds can be withdrawn tax-free to the extent they represent a return of investment. For the self-employed, using a simplified employee pension plan, commonly known as a SEP-IRA, to invest in real estate could be even more prudent, Delahunty suggests. "The tax setup for the SEP-IRA is the same for the traditional IRA but you can contribute far more," he says. For example, a SEP-IRA owner can contribute maximums of $42,000 or 25% of compensation up to $210,000 for 2005 and $44,000 or 25% of compensation up to $220,000 for 2006.

Beaudrot says there are several rules of thumb when it comes to using IRAs to invest in real estate. "Since real estate is often a tax-favored investment that produces internal shelter and cash flow in excess of taxable income, why put such a favored investment inside another tax-favored investment?" he asks. "One should generally put tax disfavored investments, such as interest income earning property, in an IRA. It's the same reason not to buy insurance in an IRA, in most cases."

Beaudrot says leveraged real estate "will generally produce unrelated debt financed income (UDFI), thus potentially defeating the whole purpose of using a tax-deferred investment vehicle like an IRA." And, he notes a conventional IRA "has the effect of converting low tax rate capital gain into high tax rate ordinary income. However, this must be balanced against the advantages of deferral and reinvestment tax free."

Beaudrot notes gains from investment real estate can be deferred through the tax-free exchange provisions of IRC Section 1031. "Therefore, you do not need an IRA to get the ability to defer taxes as long as you stay in real estate," he says. "Real estate inside an IRA makes sense when it is unleveraged, long-term hold property with huge upside potential where the deferral of gain and ability to diversify the sales proceeds on a pre-tax basis may justify it."

However, he continues, "in general, IRAs should hold income producing assets, while the capital gain producing and tax advantaged real estate investments should be outside of an IRA." The issue is more complicated when the IRA is an investor's only source of investment funds. In some cases, investment diversification goals outweigh potential tax disadvantages. Beaudrot stresses, "You can really stub your toe by buying real estate inside an IRA."

Edwards says the possible benefits in using the IRA funds are the tax deferral status of both earnings received from the property and the potential appreciation on the sale of the asset. "Long-term owners of real estate can maximize returns that can outperform the public equity and fixed income markets," he adds.

On the restrictions side, Edwards notes several drawbacks. The IRA funds cannot be used to buy a primary residence or vacation home. "Typical banks and brokerage firms that handle tax deferred accounts do not handle the trustee responsibilities associated with a self-directed account for real estate," Edwards says. "Therefore, it requires a trustee that specializes in real estate and there is a fee associated with this." Annual fees to trustees can range from $50 to $250, according to industry sources.

Annual reporting on the value of the asset has to be made to the trustee. Existing ownership in a property can't be transferred to an IRA. And finally, Edwards cautions, the buyer using IRA capital "must have a long-term hold philosophy because of the potential tax consequences for an early withdrawal." He says it is imperative to consult with a tax-planning specialist to determine specific tax implications before turning to IRA funds for capital in real estate acquisition deals.

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