Padding your retirement with real estate

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NEW YORK (Money) -- Question: I have a chance to pick up two ocean-front condos on the east coast of Florida for about $85,000. I was thinking of buying them in an all-cash deal with my IRA account, but I'm not sure whether you're allowed to own real estate inside an IRA. Can I do this? - Bernard Grossman, Hallendale Beach, Florida

Answer: The short answer is yes, you can invest in real estate through your IRA account. But the question you ought to be asking yourself is whether you should be loading up your IRA with real estate.

A few years ago, when the housing market was booming and everyone saw real estate as a can't-lose strategy for building wealth, buying "sticks-and-mortar" real estate (i.e., actual buildings as opposed to REITs, real estate mutual funds or other securities) within IRAs was all the rage.

Indeed, a slew of advisers and investment firms were pushing everything from condos to single-family homes to commercial properties as ideal IRA investments. And a number of financial publications ran stories that made it seem as if you were an old stick in the mud if you weren't beating the bushes for a sweet real estate deal for your IRA account.

Of course, now that home prices are tanking and the people who followed the advice of the rah-rah real estate crowd have presumably seen the value of their IRA accounts plummet rather than soar, you don't hear as much about the virtues of devoting IRA money to real estate.

So what's my stance on this strategy?

Well, I was skeptical of it during real estate's heyday, as you will see if you read the Long View column I wrote on this topic back in the summer of 2005. And I still don't believe it's a good idea for most people even now.

Granted, now that house prices have come down since their boom peaks, you can argue that the potential long-term returns for investing in real estate are higher now than they were just before the housing bubble burst.

But it's not as if all's clear on the real estate front. Given rising home foreclosures, stricter standards for getting home loans and the general economic malaise, it's likely that house prices will continue to fall for some time. (For more on the prospect for real estate prices, see MONEY's December forecast issue.)

So even if I were inclined to devote some of my IRA's assets to real estate, I certainly wouldn't feel that I have to rush to do so. But even putting the timing issue aside, I still have plenty of other reservations about putting actual real estate into an IRA.

One is that the various regulations governing real estate in IRA accounts can be a pain in the...neck to deal with. For example, all the expenses of acquiring, owning and maintaining real estate in your IRA must be paid from IRA funds as opposed to personal accounts.

So if your IRA doesn't have the wherewithal to cover, say a big assessment from your condo association, a spike in your insurance premiums or a large repair bill and you have to pay the tab from your own resources, you could be hit with a penalty for making an excess contribution.

And although you're permitted to hold virtually any type of real estate within an IRA - residential, commercial, even raw land - there are still plenty of restrictions. You can't use your IRA to invest in a house or other property you already own or, for that matter, to buy a beach house or country home that you would also use for vacations.

Run afoul of these and a number of other "prohibited transactions" - which are spelled out in IRS Publication 590: Individual Retirement Arrangements - and the penalty can be severe. In a worst case, the IRS could disallow your IRA, which would trigger taxes on the entire account value, plus a 10 percent penalty if you're under 59 1/2.

One more thing. You say you plan to pay cash for these condos. That's good, because buying real estate for your IRA with borrowed funds can be a hassle.

Since rules prohibit you from personally guaranteeing a loan against IRA assets, you must convince a bank or other lender to give you a "non-recourse" loan that's secured by the property itself. That's possible, but it can lead to other complications, such as your IRA owing tax on "UBTI," or unrelated business taxable income - a tax that also must be paid from IRA funds.

There are ways, of course, to navigate these obstacles. Indeed, a dozen or so IRA custodians that specialize in alternative investments like real estate are more than willing to help you do it (for a fee of course).

But even if you're willing to deal with all these issues, there's still the very important question of diversification. Unless you've got a very large IRA (or plenty of other investments outside your IRA), plowing $85,000 into real estate could leave you dangerously dependent not just on one asset class, but on the prospects for that asset class in just one location, the east coast of Florida. I'm an advocate of spreading risk, not concentrating it.

Bottom line: I have nothing against adding a little real estate exposure (say, 10 percent or so of assets) to your IRA or other investment accounts, as long as you're doing so as part of a long-term diversified strategy that includes rebalancing your portfolio each year.

But I believe that you can get most of the long-term return and diversification benefits of real estate with a lot less effort by investing in REITs or real estate mutual funds (two of which, Vanguard REIT Index and Cohen & Steers Realty Shares are on our MONEY 70 list of recommended funds than buying actual bricks and mortar.

But if you prefer to do this the hard way, well, at least I hope I've given you a better sense of the challenges you'll face.