The Bottom Line: Reader Q&A

Q. I read the article ("Entrepreneurs and Investors Maximize Investment Returns by Using Their IRAs") about investing in real property within one's Individual Retirement Account. Did the article suggest that one could purchase investment real estate with IRA money or only make loans to entities investing in real property? Either way, can you point me to the IRA regulations that allow this practice, because I have specifically asked this question of my tax adviser, who informed me that it is not allowed by the Internal Revenue Service. -- Greg Retzlaff, Sherwood

A. You can buy investment real estate with an IRA and make loans to entities investing in real property. Your IRA even can make loans to people having nothing to do with real estate, although it's good strategy to have the security of real property as collateral if the borrower ever were to default.

As to your question about the exact IRA regulations that allow this practice, I turned to David Nilssen, chief executive and education director for the nation's largest IRA facilitator, Seattle-based Guidant Financial Group .

Here's his reply:

"The Internal Revenue Service does not have a listing of IRA investments that are 'approved.' Rather, it lists two types of investments that are not approved for an IRA.

1. The first limitation is that an IRA cannot invest in life insurance contracts. IRC 408(a)(3).

2. The second limitation is that an IRA cannot invest in collectibles. IRC 408(m)(1).

"Other than those restrictions, an IRA can invest in anything, including real estate."

Truly self-directed IRA investing does come with additional rules and regulations that apply whether you invest in real estate or mutual funds.

* First, Internal Revenue Code 4975 stipulates that your IRA can't do business with any "disqualified person." A disqualified person would be you, your spouse, anyone up or down your bloodline, their spouses, your IRA fiduciary (the trustee, administrator or custodian), or any entity owned 50 percent or more by one of the disqualified people above. Hence, your IRA-acquired investment property can't be rented, sold or purchased by or from anyone on that list.

* Second, your IRA investments must be "passive.' They can gain income and appreciation on their own, but you can't make a day job out of, say, flipping IRA properties or developing IRA-held land. That could trigger the unrelated business income tax under IRC 511. The tax is 15 percent to 35 percent of the gains (the first $1,000 is exempt), but it applies only to the profit after deductions and expenses."

"Sometimes it's not very much at all, so UBIT – if it's ever triggered -- is not a huge issue for most people," Nilssen says.

* Third, if an IRA needs a mortgage or outside loan to fully pay for the real estate, the profits made as a result of the loan are considered unrelated debt-financed income under IRC 514 and are taxed at 15 percent to 35 percent. Remember though, this tax takes away just a portion of the money you perhaps otherwise could not have made.

Trusts and real estate developers have been using this strategy for years, with about $12 billion in retirement-account-controlled funds invested in real property by 2000, according to the U.S. Treasury Department. So, Nilssen checked case law and IRS rulings for any cases that might indicate whether these investors were correct when held up to the scrutiny of judges. He found only two that directly related.

* In late-1993 an advisory opinion from the Department of Labor -- the agency that regulates all work-related retirement funds -- lays out a situation where an IRA owner proposed to purchase real estate with his IRA and then lease that real estate to a school founded by the IRA owner's daughter on a "pay if you can" basis. The opinion letter raised not one question about the real estate purchase.

Incidentally, the proposed lease was prohibited for two unconnected reasons: 1) the daughter was a disqualified person and 2) the pay-if-you-can lease violated the IRS's "exclusive benefit rule," established with the 1974 creation of IRAs, that stipulates all self-directed investments must exclusively benefit the IRA. Payments that are intermittent or absent benefit the borrower, but not the IRA.

* A circa-1992 technical advice memorandum from the Internal Revenue Service details an employer-sponsored retirement plan that purchased a hotel through a limited partnership. Again the IRS did not challenge the real estate purchase. The deal was deemed prohibited only because the individual plan fiduciaries owned 7.5 percent of the limited partnership, and plan fiduciaries cannot benefit from retirement plan investments under the Internal Revenue Code.

Given these complexities, however, many certified public accountants, attorneys and financial advisers are unfamiliar with the rules. For information, you can turn to an IRA facilitator, which serves as an intermediary between the IRA custodian and the account holder; an IRA custodian that allows real estate investments; or one of the growing crop of handbooks on the subject of nontraditional IRA self-direction.

Send your finance questions to Jennifer D. Meacham at IRA@jennifermeacham.com. Jennifer is also the co-author of the best-selling book "IRA Wealth: Revolutionary IRA Strategies for Real Estate Investment" (Square One Publishers, $16.95)

BONUS: View a short slideshow from Guidant Financial Group on IRA self-direction.

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