Investing your cash in real estate can be enormously gratifying. You can fix up an ugly home and sell it for more money. You can buy undervalued property, fix it up, manage it and bring in a steady flow of income.

Or, you can take an undeveloped piece of land, and build something that will add value to the community and fatten your wallet at the same time.

The way most investors start buying property is to purchase a home they will live in. A small house, or a condominium provides plenty of training for the next step up when you might take out some of the equity and purchase a rental property, or rent out that house and purchase another.

But now a new idea seems to be emerging. Through articles on websites, seminars and companies marketing the idea to some of their account holders, some consumers have latched onto another potential source of real estate investment dollars: Your retirement account.

Over the past six months, I have received more than a dozen letters from consumers asking me about using the funds in their IRA or 401(k) accounts to purchase investment real estate. They’ve been told that they can put their cash into another account, and someone else will actively manage the real estate.

Sounds great, right? Spread the risk and let someone else, a real estate expert, buy investment property. Unfortunately, investing your IRA or 401(k) funds into investment real estate appears to be prohibited by the IRS.

According to Glenn Sulzer, a senior tax analyst for CCH, Inc., one of the largest publishers of tax information for businesses and consumers, real estate investments are not one of the permitted uses of retirement accounts, including conventional or Roth IRAs, 401(k) accounts, SEP IRAs, Keoghs, or other types of retirement accounts.

“Generally, the rule is you cannot as an IRA owner use your assets to invest in real property. It’s not permitted,” states Sulzer. Investing in real property, or real estate, is “viewed as a prohibited transaction. The (tax) code precludes investment in self-dealing transactions. The IRA owner is viewed as disqualified person which means he cannot use assets to invest in prohibited transactions.”

The only permitted transactions for a retirement account include buying and selling mutual funds, bonds, certificates of deposit (CDs) and the stocks of individual companies. The only way to purchase real estate with retirement account dollars is to purchase a real estate investment trust (REIT), which is essentially a mutual fund made up of bridges, hospitals, apartment buildings and other sorts of real estate, or mortgages for commercial or residential real estate, or a combination of the two.

The tax court views these rules strictly, says Sulzer. “They specifically preclude IRA assets to purchase residence while the assets are in the account.”

401(k) accounts are even more limited in the investment choices, even if the plan is self-directed, meaning you get to choose the investment that you want, explains Sulzer. Typically, a company will choose a handful of mutual funds and permit employees to invest in their fund of choice out of the different funds offered.

Sulzer says that after you reach retirement age and take cash out of the retirement account – and pay any taxes or penalties owed – you can do what you like with the proceeds. But the IRS does not permit IRA holders to purchase retirement homes with cash that’s held in an IRA account because it could be a way for the account holder to avoid paying taxes.

“The concern is that the individual may be trying to shelter that income,” Sulzer said.

“The thing with a SEP, 401(k), 403(b), 457 plan, Keogh or any other kind of retirement account is the future obligation,” noted Sulzer. The account holder owes taxes on this income because it was deducted from their check before taxes.

“If the 401(k) plan administrator allowed you to invest in something that wasn’t sound, like real property, they could open themselves up to fiduciary breach suits,” Sulzer said.

IRS Publication 560, “Retirement Plans for Small Businesses (SEP, SIMPLE, and Qualified Plans”) discusses prohibited transactions on page 15.

It lists the prohibited transactions as including “any of the following acts between the plan and a disqualified person, including (a) selling, exchanging or leasing property; (b) lending money or extending credit; and (c) furnishing goods, services or facilities.”

“You are a disqualified person if you are any of the following: (1) a fiduciary of the plan; (2) a person providing services to the plan; (3) an employer, any of whose employees are covered by the plan; (4) an employee organization, any of whose members are covered by the plan," and the list goes on from there.

What appears to be happening is that someone got the idea that if you hired an outside administrator for your self-directed IRA or Keogh plan, and told that person what to do, then you could tell them to buy or sell real estate just as though you would tell them to buy or sell 100 shares of IBM.

One individual, who emailed me with some of his research, reminded me that people were using 1031 Tax Free Exchanges to defer tax on commercial or investment property years before it became legal.

It took a specific law to make 1031 Exchanges legal. Until then, those individuals who made use of them ran the risk that the IRS could rule against them and they would owe penalties. For those who decide to invest their IRA assets in real property, you run the very real risk that when the IRS turns its attention to this issue, you will wind up owing a large penalty.