How To Use A Self-Directed IRA For Real Estate Investing

An individual retirement account makes it simple to invest in assets like stocks, bonds and exchange-traded funds (ETFs). But there’s a special type of IRA called a self-directed IRA that lets you own alternative assets like real estate.

For some people, a self-directed IRA could be a way to invest tax-advantaged retirement funds in real property. But there are tons of rules governing everything from property ownership and usage to how you cover expenses and take profits. Inexperienced investors can easily run afoul of the IRS.

What Is a Real Estate IRA?

A real estate IRA is just another way of calling a self-directed IRA that’s designed to hold investment property.

You can own a wide range of property types in a real estate IRA, including land, single and multi-family homes, international property, boat docks, commercial properties and more.

Since this is a type of self-directed IRA, the custodian—the company safeguarding your account and enforcing IRS regulations—allows you to hold alternative asset classes like real estate.

How Real Estate IRAs Work

The first step to using a real estate IRA is to find a custodian that allows or even specializes in real estate IRAs. Unfortunately, many of the top IRA custodians don’t dabble in real estate IRAs.

Custodians that work with real estate IRAs typically charge higher fees than regular IRA custodians, so remember to factor in those costs.

Once you open a real estate IRA, you’ll need to fund your account—typically with a rollover from an existing IRA. With your cash in place, you can buy real estate and have it titled in the name of your IRA.

You don’t necessarily have to come up with a giant pile of cash to buy a property outright. You can finance real estate in your IRA with an investment property-specific mortgage. Then, you can pay the mortgage using additional cash from your self-directed IRA.

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When you sell a property held in a real estate IRA, the funds remain in the account. Depending on the type of IRA you’ve selected, those funds grow tax-deferred (traditional IRA) or tax-free (Roth IRA).

Real Estate IRA Rules

While a real estate IRA lets you diversify away from stocks and bonds, there are a wide range of special rules governing this specialized type of account. Here are some of the key rules to understand, so you don’t run afoul of IRS regulations.

Property Title

Real estate that is held in a self-directed IRA is owned by the account, not by you personally. That means the title documents that confirm ownership of the property are in the name of your IRA, rather than in your name. A typical title would read something like “[Custodian name] FBO [your name] IRA.”

Expenses and Income

All expenses and income flow into and out of your real estate IRA. All property taxes, utility bills and other expenses are paid by your account. All rental income or other income is paid back into your account.

Limitations on Use

If you have dreams of you or your family living in real estate owned by your IRA, banish the thought. Real estate held in a self-directed IRA can only be an investment property.

Under the IRS rules, you and any member of your family—plus any of your beneficiaries or fiduciaries—are referred to as disqualified persons. Since the purpose of an IRA is retirement investing, these disqualified persons can’t make use of the real estate assets.

Forget About DIY

If you need to fix up or repair property held in a real estate IRA, the account must pay for the work. It can’t be performed by a disqualified person—that’s you.

Prior Property Ownership

You can’t sell, lease or exchange property you already own to your real estate IRA. Doing so is called “self-dealing,” which the IRS strictly prohibits.

Watch Out for the UBIT

If you take out a loan that’s secured by the property itself—a so-called non-recourse loan—you’ll have to pay unrelated business income tax (UBIT) on any profits related to the financed portion.

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For example, if you have a $1,000 annual profit and 50% of the property’s value is financed, you’ll owe UBIT on $500.

Fortunately, you can use depreciation and operating costs to reduce your tax bill. Doing so can allow you to reduce your UBIT or eliminate it altogether. You’ll need to work with a qualified accountant who understands these unique rules, so add in their costs when considering a self-directed IRA.

Pros and Cons of Using a Self-Directed IRA for Real Estate

Pros

  • Time horizon. Real estate tends to appreciate over the long term, which makes sense for retirement investors with a very long time horizon.
  • Diversification. Owning real property can help you diversify away from major asset classes like stocks and bonds.
  • More personalization. You can choose individual properties with a real estate IRA instead of being beholden to the choices made by the managers of a real estate investment trust (REIT).

Cons

  • Loss of tax benefits. When you own real estate in an IRA, you lose tax benefits you’d otherwise receive, including deferred capital gains and 1031 exchanges.
  • Special custodian requirements. It may be challenging to find a real estate IRA custodian, which may charge much higher fees than comparable IRA options, eating away at your returns.
  • Lots and lots (and lots) of rules. From who can live in a property to how money flows in and out of your account, you’ll need to abide by a sea of IRS rules—or literally pay the tax and penalty consequences.

Why Hold Real Estate in an IRA?

Given the wide range of REITs and real estate funds that are available, all of which spread risk across multiple properties, why would investors opt to hold property in their IRA?

According to Mallon FitzPatrick, a certified financial planner (CFP) in New York City, there are a couple of situations where a real estate IRA makes good sense:

  • Be ready for opportunities. If a killer property comes along but you’re short on ready cash to make the purchase, a real estate IRA could make sense if it’s the only available source of funds.
  • Potential tax advantages. If the income you earn from a property (after expenses and depreciation) would be greater than the appreciation you expect to see, it might make sense to own it in a tax-deferred IRA. That’s because ordinary income taxes might really eat into your returns on property owned outside the account.
  • Creditor protections. Depending on state laws, investors in some locations could enjoy creditor protections for real estate held in an IRA.
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Why You Shouldn’t Hold Real Estate in an IRA

There are situations where a real estate IRA is more a hindrance than a help.

  • Required minimum distributions. If you are at or near the age when required minimum distributions (RMD) begin and you’re unable to sell off real estate assets in time for an RMD deadline, you could face a fire sale to avoid IRS penalties.
  • You like fixer-uppers. fixer-upper properties may not be suited for real estate IRAs, especially if you don’t have the cash in the IRA to cover repairs.

How to Use a Self-Directed IRA to Buy Real Estate

If you’re set on using a self-directed real estate IRA for real estate investing, here’s a simple four-step process to get you started:

1. Choose a custodian

Research different real estate IRA custodians and open an account. You’ll need to decide what type of IRA to open (traditional, Roth, SEP) at this time.

2. Fund your account

You’ll fund either with cash up to the annual contribution guidelines or through an IRA rollover. Rollovers must be like-to-like, or between two IRAs of the same type. If rolling over funds from a traditional IRA into a self-directed Roth IRA, you’ll need to do a Roth conversion and pay the necessary taxes.

3. Check the rules

Review the IRS guidelines to ensure that the property you buy and its intended use and inhabitants don’t break any rules. As with any other real estate purchase, do your due diligence before entering into a purchase agreement or applying for a mortgage.

4. Buy real estate

Decide how you’ll pay—cash purchase or financing—and proceed with escrow. Remember that all funds for the purchase must be paid or wired by your real estate IRA.

Once escrow is closed, you can rent or lease the property—so long as it’s not to a disqualified person. Then, your real estate IRA must pay all expenses and receive all income.