Fertile ground for retirement funds?

After two years of watching her retirement nest egg shrink as the stock market dropped, Karen Johnson decided it was time for an alternative investment strategy.

So she pulled $8,000 from her individual retirement account and reinvested it in a parcel of raw land on the outskirts of Lancaster that she believes is in the path of Los Angeles’ residential growth.

Surprised that Johnson could use her retirement money? Few consumers are aware that they can invest their IRA funds in real estate and that it has been allowed for more than 25 years. But public awareness of this option is increasing as huge chunks of wealth have evaporated in an anemic stock market.

While these “real estate IRAs” have some complicated rules, there’s virtually no limit to the type of residential or commercial transactions allowed. Single-family houses, apartment buildings, farms, shopping centers, office buildings, hotels and undeveloped land all qualify.

To increase their buying power, investors can pool separate IRA accounts to form limited partnerships or limited liability corporations. These partnerships range from spouses who merge their IRAs to people with fairly new IRAs that haven’t yet accumulated substantial savings.

“You name it and you can invest in it,” said Patrick Rice, president of IRA Resource Associates, a Camas, Wash., firm that facilitates such deals.

Johnson, 48, a Northern California event marketing specialist, opted for land. She joined a group of investors who pooled funds to buy a 17-acre parcel in Lancaster, banking on the land’s potential for appreciation down the road.

Many IRA savers who hold real estate in their accounts prefer undeveloped property, according to Jeff Cohen, vice president of the IRA department for Arrowhead Trust Inc. in Irvine. Raw land is easier to deal with, Cohen said, and has fewer expenses.

About 35 million households nationally own about $3 trillion worth of IRAs, mostly invested in stocks and bonds sold by brokerage houses, banks, mutual funds and insurance companies. Less than 1% of the retirement money involves real estate or other nontraditional investments, according to Rice. But that’s changing, as more people become aware of the real estate option.

“People are just looking for new options for their IRAs,” said Bonnie MacKinnon, a real estate agent with Ace Capital Group, Redwood City, Calif., which put together the Lancaster land deal. “People are really hurting from the stock market, and a lot of people got caught up in the tech wave.”

Traditional IRAs, to which individuals this year can contribute a maximum $3,000 annually, or $3,500 if age 50 or older, have been allowed to hold real estate since the program’s inception in 1974. Still, that option comes as a surprise to most IRA savers and to many professionals as well.

One reason consumers haven’t heard about real estate IRAs is that there is little profit incentive for financial institutions, which primarily sell stocks and bonds to IRA accounts.

“Why would they tell you about real estate?” Rice asked. “That would mean the money would go out of their pots, and they couldn’t make money on it anymore.”

Savers with Keoghs, simplified employee pensions or Roth IRAs or those who have rolled their 401(k)s into an IRA after retiring or changing employers are eligible.

In addition to the benefits of potential appreciation, the capital gains tax on an IRA-sold property can be deferred or eliminated in some cases. Another bonus is that any rental income goes directly into the IRA account. Keep in mind, however, that real estate goes through boom-bust cycles. Values could be stagnant or in decline when it’s time to sell. And real estate IRAs have potential pitfalls with harsh financial penalties for transgressions.

Most savers will want to work with an expert to convert a traditional IRA into a self-directed IRA and to stay within the rules. These professionals include IRA custodians, who act as trustees for the account; IRA advisors, who locate real estate investments; and IRA administrators, who handle record-keeping chores, including collecting rents and paying bills.

Tom Anderson, chief executive of San Francisco-based PENSCO, which specializes in the administration of IRAs that invest in real estate, cautions that real estate IRAs are not a do-it-yourself proposition. “We don’t recommend this for people who are not sophisticated investors or not working with advisors,” he said.

One sticky area for IRAs holding real estate is that the property cannot be for your own use. A beautiful house at the beach and a gorgeous weekend may seem awfully alluring. But neither you, your spouse, your parents nor your children can own or use the property as a personal residence. (Strangely, your sister or brother can.) Likewise, you cannot use your IRA’s commercial space for your own business.

Break the rules and you could lose anywhere from 15% to 110% of your IRA’s value, including penalties.

Another potential quagmire: Once an IRA purchases a property, the account must contain enough cash in reserve, or have enough rental income, to cover operating expenses.

“You also should have a reserve of cash because emergencies might come up,” Cohen said. The account could use the cash on hand to fund a temporary loss of income, fix a leaky roof or make other repairs.

If the account has inadequate funds, you can put in new cash to cover the shortage. But the IRS will impose a 6% penalty on any additional contribution beyond the maximum annual limit. The penalty does not stop until the excess contribution is removed from the account.

Property management can pose a considerable expense, from 6% to 10% of monthly rents, and may not be cost-effective for individual houses and small apartment buildings.

Whether an IRA holder can take on property management chores to hold down costs depends on the flexibility of individual facilitators. Some will allow the holder to collect the rent check and send it to them uncashed or arrange for a plumber to make repairs, but have the facilitator pay the bill from the IRA account.

IRA holders must also be cautious about mandatory distribution, which the IRS requires once savers reach age 70 1/2. So the IRA must generate enough income to provide for the distributions. Otherwise, the IRS will assess a hefty 50% penalty on the amount of the minimum distribution the IRA holder should be receiving.

There are several ways to raise funds if the IRA needs cash for emergencies or mandatory distributions. Funds can be merged in from another IRA, the real estate can be refinanced or it can be sold.

Real estate IRAs with mortgages may also trigger the Unrelated Business Income Tax, or UBIT. This takes effect when the leveraged real estate produces profits of $1,000 or more in any one year. The hit is up to 39.6% of the capital gains beyond $1,000.

For many smaller properties, expenses offset any income. But applying the excess gain to the loan principal can reduce the tax.

And the tax burden disappears one year after the loan is paid off.

“Then at the time of sale, all the capital gains will go directly into the IRA tax-deferred,” Anderson said. “And if it’s a Roth IRA, it’s tax-free.”

Hedging her bets, Johnson has kept a portion of her IRA funds in the stock market. But the Lancaster acreage provides a measure of comfort even if the residential development fails to materialize or the stock market doesn’t recover.

“If we retire and nothing happens,” Johnson said, “we’ll go just put a tent there, and we won’t be in the street with everyone else.”

*

(BEGIN TEXT OF INFOBOX)

Adding real estate to your portfolio

If you’re interested in diversifying your IRA portfolio with real estate, begin by finding an IRA facilitator to help set up and administer the real estate IRA.

Facilitators can be found on the Internet. Go to a major search engine and type in “self-directed IRA.”

Firms that offer assistance fall into three categories:

* IRA custodians, or trustees, hold title to the property for your IRA. They can handle all paperwork and record keeping.

* IRA administrators are agents for custodians or trustees and assist with paperwork and record keeping.

* IRA advisors will find real estate investments. They also work with administrators and custodians.

It’s a good idea to shop around because fees can vary widely.

One IRA expert, for example, conducted a price survey of a dozen custodial firms and found that their annual fees ranged from 0.5% to 1.5% of assets for the same service.

Before you sign on with an IRA facilitator, check to make sure that the company is legitimate.

Ask the company if it is regulated, by whom and how to contact the regulator.

Regulators include the NASD, formerly known as the National Assn. of Security Dealers; Federal Deposit Insurance Corp. and state entities such as the California State Banking Department. Also check with local Better Business Bureaus.

“The selection of a custodian is critical,” said Tom Anderson, chief executive officer of PENSCO, a trust company with offices in San Francisco that administers real estate IRAs.

“You need to deal with a company that is regulated for safety standards. You want someone with references.”

Once you find a self-directed custodian or trustee, you can open a new IRA, transfer your existing IRA or roll over funds from your 401(k) if you are retiring or changing employers.

Next, find the investment real estate, using an advisor or a real estate broker.

Send a letter directing your new custodian to purchase the real estate for your IRA.

The process is reversed when you want to sell.

Corrie M. Anders can be reached at newzclick@aol.com.