real estate in an inherited IRA
I have a client who owns a professional building in his self-directed IRA. He would like his children to inherit the building when he and his wife pass away. They are considering a trust to hold this inherited IRA asset worth about 900k. The building has enough income to generate RMD’s to the children and he has other non-real estate IRA assets of about 1 million. Is this possible and what are the benefits/downfalls?
Permalink Submitted by Alan - IRA critic on Thu, 2016-04-07 01:01
Yes, it is possible to name a trust or testimentary trust as the beneficiary of the IRA. Hopefully, the client is by now well aware of prohibited transactions and other restrictions that apply to self directed IRAs and he is confident his children will be able to deal with these complications. The trust must be qualified for look through treatment and if so the oldest trust beneficiary’s life expectancy will be used to calculate the beneficiary RMDs. Like the client can do, an IRA beneficiary can aggregate RMDs between IRA accounts inherited from the same decedent. The main risk here is prohibited transaction regarding the real estate, such as paying the property taxes or repair bills from other than IRA funds. If that were to happen, the inherited IRA would be subject to a taxable distribution of the entire IRA balance. Again, the children would have to deal with the technical requirements of the trust, inherited IRA RMD rules, and alternative IRA assets so that could be a fairly complex mix of requirements.
Permalink Submitted by Nathan Kastner on Thu, 2016-04-07 14:16
I am aware that the horse has already left the barn with respect to what I’m about to say, but I trust your client recognizes that real estate inside of an IRA is rarely a worthwhile endevor. In my experience, self-directed IRAs are mostly used by people that insist on trying to “game” the system, and in almost all cases, they end up spending $10 just to save $5. It has also been my limited experience that they won’t listen to a word of this post, no matter what. But, for anyone else out there…. Self-directed IRAs are always more administratively expensive than a typical IRA. The companies that offer them simply charge more (a lot more) because of the administrative hurdles that are involved. And RE inside of an IRA can’t take tax deductions depreciation (and RE is frequently only profitable BECAUSE of the depreciation deductions). Not to mention, the property can’t be pledges as collateral, which precludes the beneficiaries from ever getting a mortgage or equity line against the property, which might become a big deal if they ever find themselves facing expensive repairs or upgrades (remember, the IRA must pay all expenses). And, of course, there’s a number of tax problems. Most notable are the lack of step-up in basis at death and that any gain from selling the building will be an ordinary gain, not a capital one. And, in the off chance the building were ever sold at a loss, the loss wouldn’t be allowed. RMDs are also going to be a pain in the behind. Calculating an RMD requires knowing the value of the account on 12/31 of each year, which means constant valuations that are sufficiently acceptable to the IRS. And god help them if they live long enough to see RMD factors that are large enough that they can’t generate the income to meet them. At age 90, the mandatory withdrawal is roughly 9% of the building’s value. How many rentals are consistently generating that amount NET of expenses (which, again, must be paid from the IRA) and not getting to take a depreciation deduction? The answer – not many, and even fewer do it consistently, every year. What if the tennant ever moves out, even if only for 3 months before finding another? What if the building catches fire, rendering it uninhabitable for a year? Like I said previously, there are simply so many hurdles, headaches, and pitfalls involved in IRA owned real-estate that I simply can’t remember the last time I saw one of these being a good idea in the long run. As an aside: I’ve worked with a few trustees on similar arrangements to this one. It’s not uncommong that when the trustee and the beneficiaries find out everything I’ve posted above, they are just going to say “to hell with it”, distribute the building from the IRA, pay a massive amount of taxes, and move on with their lives.
Permalink Submitted by Erwin Buck on Thu, 2016-04-07 15:08
If I could convince him to sell, which is possible after both of you sharing great wisdom, what would the consequence be for the IRA?