Purchasing STR’s with inherited IRA funds?

Question

I have a unique situation with an inherited IRA from a sibling that passed a few years ago. I could potentially purchase 3-4 units (down payments) with funds from this account over the next few years still leaving a good amount in the account.

My main question is how would you analyze if this would be a good idea or not? Feds get 10% right off the top for whatever comes out of the account but I’m required to take a small amount out yearly as is. I understand diversification of your entire portfolio but would this be a “smart” idea?

Daniel Murphy · Answer

did your sibling pass before, or after Jan 1, 2020?  If it was before, you fall under the old rules where you have to withdraw the balance of the account over your IRS life expectancy.

If it was after, you have to withdraw the account out within 10 years.  This makes a big difference.

You shouldn't be penalized the 10% IRS penalty, just taxed at your marginal tax rate.

So... If you are required to withdraw the account out within 10 years, it makes a lot more sense to withdraw the funds incrementally to purchase property.

Here's some easy math / ideas... Take your income (joint if filing jointly), subtract any 401k contributions.  Then subtract your standard deduction $13,850 if single, $27,700 if filing jointly.  This is an estimate of your taxable income.

Then, google your 2023 tax rates.  I'd say as long as you can keep yourself within the 22% tax bracket (or up to 24% potentially) it would not be a bad idea to withdraw the inherited IRA funds to purchase real estate.  Take the upper amount of the tax bracket minus your estimated taxable income.  The difference is how much you could theoretically withdraw from the IRA this year and still stay in the 22% (or 24%) tax bracket.  If you end up above the 24%, it gets tricker as now you are in a "high" tax bracket.

Leslie Anne Morris · Answer

I cashed out an entire IRA to get started investing and never looked back.  I scaled in 3 years to 10 STR using this method.

Brian Eastman · Answer

@Michael Baum

The IRS is not specific that you can do "X" and cannot cross threshold "Y".   Everything is interpretation, and you and your counsel get to decide what your risk tolerance is.

What you cannot do is add value to the IRA through the provision of goods or services.

Even deskwork could be viewed as crossing a line if the level of activity is high enough.  As a long term landlord, for example, managing a handful of doors would be no issue, but how much work are you doing if your IRA owns 30 doors?  Similar with STR.  If you are spending 6-8 hours a week managing the property(ies), that could be viewed as providing services to the IRA.

We recommend against self-managing short term rentals in an IRA.

Brian Eastman · Answer

@Wesley Myers

There are two approaches, each of which could make sense based on your situation and goals.

You could take distributions from the IRA as needed to acquire properties personally.  As you draw from the IRA, you will pay tax at your marginal rate.  Of course, the more you take out at one time, the higher that rate will climb, so you may want to do something like buy one new property per year for several years to spread out the tax hit.   In this case, you would own the properties personally.

You could also explore using a self-directed IRA.  In this case, the IRA would own the properties and all income would go back into the IRA.  This would allow you to potentially continue to grow the IRA if the amount of income the IRA earns is less than the amount you are required to take out.  You can choose to take out more than the minimum required amount.

Because the IRA remains tax-sheltered, there are restrictions related to keeping the IRA at arm's length.  You cannot work on the properties or otherwise provide services to the IRA, which with STR likely means getting a property manager.  A long term rental may be better suited to an IRA because it is more passive and can be self-managed in many cases.

I suggest you do a little research on the self-directed IRA route to see if it makes sense for you.  Then, meet with licensed counsel to do a real comparison of outcomes with the personal vs IRA strategy.  Depending on how much is in the IRA, you could potentially do a bit of both.

Greg Scott · Answer

If you can find deals that generate strong returns, paying the 10% penalty and ordinary income will be a no-brainer decision because you can make the taxes back in a short period of time.  If you can't find good deals, I'd wait.

If buying these rentals allows you or a spouse to qualify as a real estate professional, most or all of the taxes for withdrawing the funds could be offset, making it an even easier decision.

Todd Goedeke · Answer

@Brian Eastman good complete answer about self managing. All the more reason that retirement fund investors lease their STVR property to a management company using a triple net lease or master lease to avoid a prohibited activity.

Todd Goedeke · Answer

@Wesley Myers there is no automatic 10% taken off the top if you do a direct transfer. The monies are sent direct or transferred at same institution to an inherited IRA in your name.

RE in an inherited IRA will work as long as you realize you will have to take a distribution in kind of a portion of the RE value each year. If you invest part of IRA funds in more liquid investments, then you might not need to distribute any RE assets in kind the first couple years. Distributing in kind does not mean the asset is sold.

Michael Baum · Answer

Thanks @Brian Eastman. Answers to this are all over the board. Some are like you and say no way. Other CPA's say sure you can as long as XXXX doesn't XXXX.

It gets confusing.

Thanks!

Michael Baum · Answer

Hey @Brian Eastman, just a quick question regarding self management. I have been reading up on this and so far the IRS doesn't prohibit self managing as long is it is "desk work". Scheduling guests and cleaners. Getting maintenance scheduled etc. As long as you aren't swinging hammers, wielding paint brushes or toilet brushes it seems to be OK.

In your understanding of the IRS rules, would you agree with that assessment?

Wesley Myers · Answer

Very helpful info so far thank you. She passed just before Jan 1 2020 so we’re under the old rule. I should clarify I withhold 10% for taxes you are correct it’s not a penalty.

Purchasing STR’s with inherited IRA funds?

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