A growing number of commercial real estate investors are finding green in one of the last places they might have thought to look: their own backyards. They are discovering that money held within their retirement accounts, such as Traditional and Roth IRAs, can be used for real estate investments.

Although the option of investing in real estate within a retirement plan has been available since 1974 when IRAs were originally developed, it has only recently gained popularity. One reason may be that it has taken this long for the general population to build up enough wealth in their retirement accounts to make this a do-able alternative to traditional funding sources. It is estimated that more than $500 billion of retirement plan distributions will be rolled to IRAs by year 2010; meaning more investors have adequate money in their IRAs to fund real estate purchases.

The good news for investors is that the IRS does not place any restrictions on the types of real property that can be held within an IRA. Office or apartment buildings, strip malls, warehouses, even parking lots are all viable options. However, real estate purchases and sales within an IRA can be full of twists and turns, so it’s wise for investors to work with their professional advisors for legal, tax and investment advice.

Structuring the Deal

The money from an IRA can fund all or a portion of the commercial real estate purchase. When the IRA monies account for only a portion of the deal, common structures include tenants-in-common, a LLC or a private REIT. No matter how the deal is structured, it is important to know that all expenses must be paid for with funds from the IRA based on the plan’s pro-rata share of the expenses.

For example, say four investors pool their money to purchase a $1 million apartment building and each investor has a 25 percent share. Investor A plans to use $250,000 from his IRA to fund his part of the deal. Twenty five percent of the expenses of purchasing, holding and selling the property must be paid with Investor A’s IRA monies. For that reason, some custodians require investors to maintain a minimum cash balance in their account. If Investor A pays directly for an expense, the IRA could face severe consequences ranging from a 6 percent excise tax to disqualification of the entire amount.

By the same token, 25 percent of any income and sale proceeds derived from the property will be deposited directly into Investor A’s IRA.

The first step is determining whether using IRA funds to purchase real estate is a smart move for the investor. Depending on the individual’s circumstances, owning commercial real estate within an IRA can provide benefits that include estate planning and tax advantages. There are also disadvantages to take into consideration. Here are some of the pros and cons investors should be aware of before pursuing this alternative.

Some Advantages

• Diversification – Buying real estate is one way to diversify an investment portfolio that primarily holds stocks, bonds and mutual funds.

• Tax Benefits – An IRA may offer certain tax advantages including income tax deductions for IRA contributions and deferred taxation of gains and appreciation.

• Estate Planning – Assets held in IRA accounts are generally exempt from the claims of creditors. In addition, purchasing property with an IRA gives the investor a way to pass certain assets to beneficiaries outside of probate.

• Financed Investments – Investors may be able to obtain financing in the form of a non-recourse loan from a lender to buy real estate in an IRA, thus allowing them to participate in the benefits of a leveraged financial transaction.

• Income – Certain commercial properties may generate positive cash flow within the IRA and depending on the type of retirement account that could mean the income is either tax deferred or non-taxable.

A Few Disadvantages

• Investors face the possibility of losing the tax protection of the entire IRA if the plan engages in what is considered a prohibited transaction. For example, living in the property and paying for expenses with money outside the IRA are both prohibited.

• Mortgage interest is not deductible for real estate owned in an IRA.

• If the stream of income requires payment of unrelated business taxable income, the trust tax rate may be higher than the individual rate.

• The value of the real estate investment, and thus the IRA, may fluctuate.

Getting Started

Whether this investment alternative makes sense for an investor depends on several factors. Some topics that investors should discuss with their financial advisor or attorney include:

• What is my risk tolerance? Time horizon? Need for current income? General preferences?

• Should I seek more diversification than what a traditional portfolio provides?

• Am I willing to take on the unique risk and management requirements of alternative investments within their retirement plans?

If the investor determines this is a good option, here is a step-by-step guide.

1. Open a self-directed IRA with a custodian.

The first step is to open a self-directed IRA with a custodian that can administer real estate as an investment. Because of the complexity involved in administering these types of IRAs, it’s important to work with a custodian that has an extensive understanding and knowledge in this area.

Here are some things a financial advisor will want to consider when looking for a self-directed IRA custodian: 1) Find one that has a specialized background in administering IRAs that hold real estate investments; 2) These types of transactions are complicated; make sure the company has an experienced service team that can walk clients through the process step-by-step; 3) Consider a custodian that can hold traditional assets – such as mutual funds – as well as alternative assets within an IRA so all IRA assets can be held with one company.

2. Transfer funds.

Once a custodian is in place, the investor will need to transfer funds from the current custodian to the new one.

3. Locate and purchase the real estate.

Once the investor has found a property that meets his investment needs he should work closely with the custodian throughout the closing process to facilitate the transaction with the investor, the real estate professional and the title company.

4. Determine a funding option.

There are a number of options to consider:

• The entire purchase can be funded from the self-directed IRA.

• If the investor is financing or leveraging the real estate purchase, the property becomes collateral for the non-recourse note.

• This may be an institutonal lender or seller-financed arrangement

• As noted above, the real estate may have multiple owners of the same property. In that case, the retirement plan would own a percentage of the property and be listed on the deed as holding that specific percentage. The other investors are also listed on the deed.

5. Submit the property documents to the custodian for review.

The custodian will inform the investor of the documents they will need. These will likely include the following: Preliminary Owners’ Title Report, copy of the unexecuted Conveyance of Deed, contract or purchase agreement, preliminary closing statement and escrow instructions.

Although owning real estate within an IRA can be a complex process, for the right investor it can provide a wide range of added benefits. And as IRA wealth continues to grow, more investors are realizing an alternative funding option might be very close to home.