If you want to invest IRA money in real estate, you’re probably better off not putting the properties themselves, or any portion of a property, into the account. Inside the IRA, the tax advantages of real estate are lost. You can’t take depreciation deductions, you can’t deduct paper losses, and you can’t take advantage of long-term capital gains. Every dollar that comes out of your IRA will be taxed as ordinary income, even if that money comes from selling real estate at a profit. Under federal law, IRAs and debt don’t mix. Therefore, you can’t hold mortgaged property in your IRA. Without leverage, you’re giving up your best chance for sizable property profits.
Instead of holding property in an IRA, consider tax lien certificates, auctioned off in many counties. The interest you receive from investing in a tax lien is taxed as ordinary income, at your highest tax rate. The same is true if you have short-term (less than one year) gains from selling a property obtained through foreclosure. Inside an IRA, those taxes are deferred until you take money out. Tax rates are scheduled to fall, under the tax act of 2001, so deferral works in your favor. Moreover, you may be in a lower tax bracket after you retire and begin to tap your IRA, so you’d be paying less tax then.