Strict guidelines govern use of IRA to buy property

The rules for purchasing real estate with an Individual Retirement Account are specific and differ greatly from those that govern conventional rentals and second homes. For example, you cannot buy a second home with an IRA and use it partly for personal use, even though you might rent it to unrelated persons the rest of the year. And, your IRA cannot purchase a real estate asset and then have a "disqualified" person (family member) use it while it is in the IRA. The purchase must be investment property only.

For investors, the biggest mistake made with an IRA-purchased property is the misapplication of the 14-10 rule. Under current federal tax laws, the owner of a rental vacation home can use it for 14 days or 10 percent of the amount of time the house is rented, whichever is greater, without jeopardizing its status as a rental property and tax shelter. This is not so with a property purchased with an IRA.

Here are the four basic "no-nos" of real estate IRAs:

Personal use (unlike rental property)

Renting IRA property to family, or a partner

Paying yourself with its income

Personally guaranteeing a loan

To prepare for your real estate IRA, designate the amount of your retirement funds that you wish to use in the property deal and open a new IRA account with an independent administrator. The best place to start is an independent community bank. Many banks will not service real estate IRAs (some will say "never heard of it") because it must act as owner -- pay the taxes, collect servicing fees -- paperwork that many lenders don't want or need.

The only exception to IRA funds being used for a personal residence is reserved for first-time homebuyers. A provision in the 1997 Taxpayer Relief Act that allows penalty-free withdrawals of up to $10,000 for the down payment and closing costs. Withdrawals can be made from established IRAs of spouses, parents, children, grandchildren or ancestors as long as they total no more than $10,000. While not subject to the Internal Revenue Service's 10 percent early withdrawal penalty, normal income taxes will still apply.

Misinformation given by local IRS offices has added to the IRA confusion. According to a federal tax-court case, a couple was charged income tax for withdrawing their IRAs to buy a home even though their local IRS public-assistance representative said the funds would not be taxable.

Emma and James Clarke each withdrew $16,000 from their IRAs. They wanted to be certain the amounts were not taxable because the Clarkes said they would not be able to purchase the house and pay taxes on the $32,000 withdrawal. According to the Clarkes, they were told no penalty would be assessed. The court ruled that when IRS employees give incorrect interpretations of the law, the IRS is not bound by that advice.

In fact, the IRS is not generally bound by the language of its own publications. The court ruled the Clarkes' withdrawals were taxable under the rules that generally apply to IRA distributions.

Owning a home is a "forced savings plan." The money that you put in to home ownership is usually returned -- with appreciation -- when it's time to sell. Sometimes the appreciation can offset the amount of interest the borrower has paid on the home loan.

If you are a first-time home buyer, however, and using your IRA funds is the only way you can afford the down payment, check with a tax professional before making the move. He might tell you the "R" in IRA is to be used in retirement and not before.

And, he absolutely will tell you that you cannot use your IRA funds to buy a second home.

Using IRAs, 401(k)s to buy a house

Question: There's a topic I'm very interested in learning about, and not sure if you've covered it in the past. But I am wondering about borrowing from 401Ks and IRAs to buy a home. What are the options? The pros and cons? Does it apply to new homes only? When do you have to pay them back? Jakki Glivicky, Boston.

Answer: My first thought about using retirement funds to purchase a house is don't. If this is the only way you can scrape up enough dough to cover your closing costs and a minimal down payment, you probably shouldn't be buying a house. But after talking to Austin, Texas, mortgage banker David Reed, I'm not so sure.

Reed's not a financial planner or retirement expert, by any means. But he once borrowed from his 401(k) to buy his present home and he told me it couldn't have worked out better.

"Worked great for me," he said. "We were house hunting and a home came up quicker than we thought. We didn't have 20% down, so I borrowed 10% from my 401(k) and got an 80/10/10." That's an 80% mortgage with 10% down and a 10 percent second mortgage or home-equity loan; in Reed's case, from his retirement money.

Now you certainly don't need to make a 20% down payment. Reed was doing it to avoid private mortgage insurance, which borrowers pay for, even though it protects lenders in case the borrower doesn't make payments. All kinds of loans are available today for as little as 3% down, or even less. But you have to pay PMI, which can add $100 or more to your payment each month.

Most financial planners have apoplexy when anyone talks about disturbing their retirement money. But let's look at this a little deeper, first the 401(k) and then an IRA.

Generally, 401(k) loans are limited to 50% of your vested balance. And the amount must be paid back each and every paycheck, usually over a four-year term. Reed, who covers this stuff in a chapter in his new book, "Who Says You Can't Buy a House?" (AMACOM), says the typical 401(k) loan -- it's not really a loan per se but rather a transfer of assets -- is at a rate of prime plus one percentage point. So if the prime rate is 6% you'd pay 7%.

Most anyone who is fully vested and a full-time employee can draw money from a 401(k). After all, it's your money. No credit report, no debt-to-income rations, no tax, no penalty for early withdrawal, no nothing. But the drawback, of course, is that once the money is removed from your account, you no longer are earning a return on it.

You can't borrow from your IRA account. You can only withdraw from it, and there are stiff penalties if you pull out money before you are 591/2 years old. The law allows you to withdraw money without penalty if you yourself are a first-time buyer -- how many first-timers have an IRA brimming with enough cash for a down payment? -- or if you want to help your child, grandchild or other direct relative buy their first place.

However, the law limits the maximum withdrawal to $10,000 for an individual taxpayer and $20,000 for a husband and wife withdrawing together. And of course, unless the money is put back into the account, and there is no requirement that it must be, it's earning power is lost forever, at least in the form of a retirement asset, unless you put it back.

Homeownership isn't a bad form of retirement asset. It may even turn out to be a better one than an IRA. But unless you are the first-time buyer, it's an asset for someone else, not you.

All in all, though, I wouldn't touch your retirement funds in any way, shape or form until you have a sit-down with a financial planner of certified public accountant.

And no, you are not limited to just new construction when you tap into your retirement nest-egg for the down payment. You can buy an existing house, too.