INDIANOLA, Iowa (DTN) -- It sounds enticing: Buy farmland with pre-tax dollars and accumulate income and gains tax-free until you sell it. That's the lure for using a self-directed IRA to invest in farmland. But there are several catches that make this a better strategy for landlords than farm operators.

Capital gains and other earnings accumulate tax free if land is owned within a Roth IRA. (DTN file photo by Scott R Kemper)

"The No. 1 deal-breaker for most farmers looking to put farmland into an IRA is that neither the owner, nor a related party of the owner, can operate the farm," explained Tom Peebles, an attorney with Kennedy & Coe in Salina, Kan.

A disqualified person (who cannot rent the ground or financially benefit from the operation of the asset) includes the owner, the owner's spouse, children, children's spouses and owner's parents. It does not include siblings or in-laws, nor does it include aunts, uncles or cousins, explained Peebles. Conceivably, the owner can be a farmer's brother-in-law who sets up his IRA to own the land and rent it out to the farmer.

So far, Peebles has set up four clients -- all non-farm operators -- with a self-directed IRA or qualified retirement plan that bought real estate.

"It's an alternative investment to the stock market where some investors don't feel comfortable or knowledgeable," he said. "But the client has to play by the rules and use the land as an investment."

Randy Hertz of Hertz Farm Management in Nevada, Iowa, can recall just one client who has used an IRA to invest in farmland. "He was an investor who rolled corporate retirement funds into a self-directed IRA," explained Hertz. By doing so, the buyer created a large lump sum suitable for making a $100,000-and-up land purchase. That's a threshold many farm operators might not have accumulated.

Another complication is that you won't want to put all of your retirement savings in one investment. To avoid being forced to sell the farm to meet minimum IRA distribution requirements at age 70 1/2, the investor should have other IRA assets besides farmland that could accommodate the IRA minimum distribution rule, advised Andy Biebl, a CPA with LarsonAllen in New Ulm, Minn., and DTN tax columnist.

The type of IRA may also make a difference in whether this is a good investment strategy. Neil Harl, emeritus professor of economics, Iowa State University, explained that any distributions from a regular IRA will be taxed as ordinary income, not capital gain. So, if the farm is sold, the proceeds from the sale will be taxed as ordinary income when your IRA distributes them to you.

However, a Roth IRA (using after-tax dollars) may be a better strategy for an appreciating asset such as farmland. Once the Roth IRA has been in place for at least five years and the person receiving the distribution is at least age 59 1/2, there would be no tax on the gain from the sale of the assets. Also, farmland in a Roth IRA could be inherited and the heirs could receive the income from the self-directed Roth IRA income-tax free for the rest of their lives, without regard to their age or income level.

The land does not receive a step-up in basis at the death of the owner, but the taxable distribution (for a traditional IRA) can be spread out over the life of the heirs inheriting the IRA, minimizing the tax consequence.

USE A TRUSTEE

Farmland in an IRA can be a good investment and tax strategy for some people, noted Quincy Long, Entrust Retirement Services in Houston, Texas. "You can invest your retirement money in what you know best and defer the taxes as long as you own the farm," said Long. Even with a regular IRA, you might come out ahead in the future.

"At this point, long-term capital gains are taxed at a much lower rate. Who knows what the future holds [for tax rates]," Long added.

In most situations, an investor will roll over an existing IRA into a self-directed IRA using a trustee such as Entrust Retirement Services. The IRA holds the title to the land. The IRA's trustee manages the income due to the IRA and pays the bills.

"For our services," said Long, "it costs $50 to open an account, $125 to acquire the asset and then $295 per year plus $5 per check for outgoing checks to maintain the account."

"The process isn't complicated," said Long. "The decision is mainly whether you want to do it or not."

If you think a farmland fits your IRA investment strategy, be sure to work with a professional. "You want to set it up carefully, because the penalties are death to an operation," warned Biebl.

In fact, they can punish both the owner and the renter, Long added. "If IRS disqualifies the IRA, it goes back to Jan. 1 of the year in which you did the prohibited transaction (which may be several years before you're finally audited) and you have to pay taxes as if all the assets were distributed on that day. Even the non-owner renter who is found to be a 'disqualified person' is penalized 15 percent per year on the value of the prohibited transaction," he said.

Elizabeth Williams can be reached at elizabeth.williams@telventdtn.com

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