Sarah and Bill have a plan. They’ve heard about investment property in Costa Rica—beautiful locations, great weather, ease of living. And the best part: property is relatively inexpensive and easy to rent for a strong cash flow. They want to use their IRAs to fund their investments, but they also would like to live on their property after they retire. If they pool their IRAs, they will be able to buy a property outright, with each of their IRAs owning a portion based on the percentage contributed. If they want a bigger property, they can include friends in the deal. One way to make the transaction is to form an entity, such as a corporation or trust, to hold the property for the IRAs. The collective IRAs become stakeholders of the entity.
They head to Costa Rica to check it out. They have a great time exploring the country and taking side trips to look at real estate. Fortune is with them, and they find a property that they both agree on. Sarah and Bill each complete a buy direction letter to instruct the administrators of their IRAs to purchase the property. Their IRAs will take title once the transaction is complete. Their representatives must work with Costa Rican attorneys and title companies to ensure that the IRAs have ownership and that all income and expenses are properly credited and debited to their IRAs.
Sarah and Bill look into taking out a loan to buy the property. They discover that all debt used for acquiring property in any IRA must be nonrecourse. Usually a corporation or foundation is put together by legal counsel in Costa Rica, which will in turn be owned by the IRA. The corporation or foundation will then be the borrower, with property income and expense flowing through the IRA-owned Costa Rican entity. Any debt-financed property, regardless of where it is located, may be subject to unrelated debt-financed income tax in the United States.
The burn is that during the time that the property is owned by their IRAs, they can’t live in it, not even for a moment. And neither can their parents, children, or children’s spouses. Bill’s older brother asked about renting the house for the winter. Although siblings are not specifically prohibited in the same manner as lineal descendents and ascendants, there are plenty of IRS rules that make living in a sibling’s IRA-funded property a bad idea as well. A safer option is for Bill’s brother to rent a nonrelated friend’s property who also used an IRA for the purchase. In the meantime, Sarah and Bill’s property is maintained by a property manager, and any maintenance must be performed by third parties unrelated to the couple.
When Sarah and Bill are ready to retire in six years to their Costa Rican property, they first need to take a complete distribution of the property owned by their IRAs, which becomes a taxable event for U.S. tax purposes. The fair market value of the property is added to their taxable income in the year of distribution. However, if they use Roth IRAs to purchase the property, they will not have to pay tax on the distribution. The distribution is a net asset value, so if Sarah and Bill have a debt against the property, the distribution amount will be based on the fair market value minus any mortgages. Any taxable distributions are reported on Form 1099-R.
Sarah and Bill’s friend Louise finds their interest in Costa Rica infectious, especially after she joins them there for a vacation. She has a 401(k) with her employer and wants to know if she can use it for real estate investment just as Sarah and Bill did with their IRAs.
If Louise’s workplace offers a self-directed 401(k), she can use it for such an investment, but it is unlikely that her employer’s plan allows this. However, her plan may have an in-service withdrawal feature that permits her to roll over a portion of her vested funds to a self-directed IRA. Once Louise retires or quits, she can roll over her entire 401(k) plan to a self-directed IRA or a self-directed individual 401(k) plan and then purchase the Costa Rican property at her discretion.