Maximizing Your Retirement Savings with Real Estate in Your IRA
Adding real estate to your self-directed IRA (SD-IRA) can be a powerful wealth-building strategy for your retirement. This asset is less common in retirement accounts than stocks or bonds, and it comes with some additional regulations to follow and hoops to jump through.
For those who have wondered about buying real property in a retirement account, I’ve put together the ultimate roadmap on how to invest in real estate with a self-directed IRA.
From understanding the basics of custodians and prohibited transactions to the pros and cons of adding this asset to your portfolio, this guide will equip you with the knowledge you need to assess whether adding real estate to a self-directed IRA is right for your financial plan and to avoid the potential pitfalls of doing so.
How to Buy Real Estate with a Self-Directed IRA
One of the greatest benefits of a self-directed IRA is the access you gain to asset classes such as precious metals, private company stock, and (my personal favorite) real estate. While you can of course invest in these assets with after-tax dollars, a self-directed IRA allows you to use your tax-advantaged retirement savings to make these investments.
However, you can’t sign into an online portal and buy an apartment complex for your IRA as you can with stocks, nor can you simply buy a property on your own and dump it into an IRA.
With that in mind, here is a step-by-step outline of how the process of buying real estate with a self-directed IRA works.
Select a custodian. A self-directed IRA must be held by a custodian—a firm that holds your funds and ensures your investments and accounts are compliant with IRS guidelines. The custodian carries out your transactions, completes the necessary paperwork, and ensures that all the administrative tasks are taken care of.
Fund your account. All purchases (including real estate transactions) must be done with IRA funds. You can roll over an existing IRA (or another eligible retirement account) to a self-directed IRA. (Annual contributions have to stay within IRS limits, which is $6,500 for people under 50 and $7,500 for those who are older.)
Identify the property. Determine what type of real estate and which property you want to buy. With the help of your custodian or financial advisor, do your due diligence to ensure that your chosen investment will be profitable and that your IRA balance can handle the maintenance and fees that the property will incur.
Close on the purchase. Your custodian will manage the transaction on your IRA’s behalf.
Maintain the property. All property taxes, fees, maintenance, and other expenses must be paid directly by your IRA, your custodian.
Pros and Cons of Investing in Real Estate in a Self-Directed IRA
While using a self-directed IRA (rather than a traditional one) opens you up to a whole new world of nontypical asset classes, this option isn’t for everybody. The ability to invest in real estate comes with huge advantages, but it has several drawbacks as well. Let’s explore a few of each to determine if this option is right for you.
Pros
Diversification. The most obvious benefit of a self-directed IRA is the exposure to asset classes outside of stocks and bonds. Real estate offers investors an excellent track record of historical returns from both rental income and appreciation.
Add stability to your portfolio. Since the need for housing never goes away, using real estate to hedge your portfolio against economic downturns in the stock market can be a wise choice.
Tax advantages. Depending on whether you have a self-directed IRA or a self-directed Roth IRA, the growth from your real estate is tax-deferred or tax-free. This can save you quite a bit on income taxes and/or capital gains taxes.
You can buy, sell, fix, and flip multiple properties. As long as you aren’t doing any of the labor yourself, you can build a real estate empire — all within the tax-sheltered confines of your IRA.
More choices. Unlike a real estate investment trust (REIT) where you are beholden to a preselected set of real estate investments, a self-directed IRA allows you to purchase whatever type and location of property or properties you want.
Cons
Diversification. Yes, diversification is a pro and a con. Investing in a new asset class (real estate as opposed to stocks and bonds) adds to your portfolio’s diversification. However, if you only hold one or two properties, your real estate portfolio may not be very diversified, as a lot of capital can be tied up in a single investment.
You pay for the property with cash (usually). Many people that purchase real estate in a self-directed IRA conduct all-cash transactions. There are a few reasons for this.
First, most traditional lenders won’t underwrite mortgages for properties in an IRA. Assets in an IRA are partially protected in the event of bankruptcy (up to $1 million), so the only collateral the loan has is the property itself, which can lose value.
Second, even if you can get financing for a property for an IRA, the leveraged portion might create taxable unrelated business taxable income (UBTI), along with a large amount of paperwork.
You forgo certain tax deductions. While most real estate investors enjoy a deduction from their taxable income from mortgage interest, depreciation, and property taxes, that’s not the case for real estate held in an IRA. The IRA itself doesn’t pay taxes, so it can’t get tax deductions. There is an exception to this when the property is leveraged with a non-recourse mortgage loan.
Maintenance can drain your balance. In my opinion, this is the biggest risk to holding real estate in an IRA, though it can be mitigated with proper planning. Because the IRA has to pay for all the expenses associated with the property, you must have a sufficient balance to cover all needed repairs, property management, maintenance, and fees. You cannot pay for any real estate expenses with your personal funds. If you believe the future availability of expense funds will be tight, consider partnering with yourself prior to the purchase of the property.
Optionally, you can contribute more to your IRA to cover those expenses, but you can’t exceed the IRA’s contribution limits of $6,500 per year (or $7,500 if you are over age 50). If you do, the excess is subject to an annual tax of 6% for every year that it stays in the account. You may be able to get around this particular issue by making rollover transactions from other retirement accounts you own.
Beyond the risk of not having enough in the account to pay for maintenance and fees, if your real estate drains your IRA balance, there is an opportunity cost as those funds are no longer able to grow inside the IRA.
Required minimum distributions can get tricky. Once you hit age 72, the IRS states that you must take required minimum distributions (RMDs) out of your IRA (unless it’s a Roth). These withdrawals can be difficult to manage if you own illiquid assets like real estate.
It is possible to distribute your real estate in kind (in the form of a portion of interest in the property), but you’ll have to have an appraisal and refile a deed each time you do so, which can be cumbersome and expensive.
Regulations of Real Estate Investments in IRA
While real estate can be a lucrative asset to hold in your self-directed IRA, there are several rules and regulations to be aware of. This isn’t a comprehensive list, but these are some of the most important ones.
Disqualified Persons
All IRA transactions must be “at arm’s length,” meaning that the IRA must be unaffiliated with the parties with which it conducts business. For this reason, the IRS doesn’t allow the following individuals to rent, buy, sell, or do work on any real estate held in an IRA:
Fiduciaries or service providers of the IRA
The owner of the plan (you)
Family members including grandparents, parents, children, spouse, children’s spouses, etc.
Any company, trust, corporation, or estate in which you have 50% interest or greater
For example, if your father owns a plumbing company, you cannot hire his company to do work on your IRA-held rental property. If your grandson’s wife is a real estate agent, you cannot hire her to buy or sell property for your IRA. All transactions must be through the IRA, for the IRA, and have no benefit to you directly.
Prohibited Transactions
Prohibited transactions involve a disqualified person receiving or benefiting from any assets that are held in the IRA. So if you own a duplex, you cannot rent it out to your children, nor can you sell it to them. If you own a vacation home, you (or any of your relatives) cannot stay in it—even for one night.
Since you, the owner of the IRA, are a disqualified person, you cannot do any maintenance or improvement on your IRA-held real estate. Because this is a non-monetary contribution to your IRA, it is treated as a prohibited transaction. As silly as it sounds, you cannot even fix a leaky faucet or mow the lawn of your IRA-owned real estate, or you face hefty penalties.
Tax on Prohibited Transactions
If you think you’re going to save a few bucks by doing some of the maintenance on your IRA-held real estate, think again. The penalty for prohibited transactions is severe—a 15% tax on the amount involved for starters, followed by 100% of the fair market value of the property if the transaction isn’t corrected.
All disqualified persons involved in the prohibited transaction can be held liable for the additional tax, so if you are at all in doubt as to whether a transaction is above board, ask your SD-IRA custodian before proceeding.
FAQs About Real Estate in a Self-Directed IRA
Since holding real property in an IRA is not as common as stocks or bonds, there are a lot of unknowns surrounding this alternative asset. Here are the answers to a few common questions.
Are there companies that issue mortgages for buying real estate in my SD-IRA?
Yes. Most buyers use non-recourse loans, which are mortgages that are secured only by real estate. Some non-traditional lenders issue these loans, and they typically want the property to be producing some kind of income.
The lender will likely require your IRA to have enough reserves for closing costs, insurance, and maintenance on the property. Interest rates will be 1% - 1.5% higher than a typical investor loan would be.
Peak Asset Lending is currently one of the only lenders specializing in non-recourse loans for real estate investors. We’ve helped dozens of our clients partner with Peak Asset Lending to find customized financing solutions for their investment properties.
What types of real estate can I purchase for my SD-IRA?
Most types of real estate are eligible for purchase in an IRA, including single-family homes, multi-family homes, apartment buildings, commercial real estate, condos, raw land, foreign land, tax liens, and more.
If I don’t have enough money to buy a property in my IRA, can I go in on one with others?
Yes. For instance, if you partnered with a friend to go 50/50 on a property, your IRA would own half of the interest in the property.
You can partner with people that would be considered disqualified persons, such as a spouse or child; they aren’t mixing their funds or interest with your IRA (which is treated as its own entity), so this is allowed. You can even partner with yourself by having your IRA buy a portion of the property and paying for the rest with your own funds.
How Chicago Trust Administration Services Can Help
Comparisons between holding real estate in your own name to holding property in your IRA are like comparing apples to oranges in many ways. The IRA is its own entity, so any benefit you receive from the appreciation or rental income of its real estate must pass through the IRA before it ever gets to your hands. The tax benefits and burdens are on the IRA, not you, and there are many moving parts, making it difficult to determine whether you would come out ahead in the end.
To fully assess whether investing in real estate using a self-directed IRA would be beneficial to your portfolio, it’s essential to get a professional’s opinion. At Chicago Trust Administration Services, we can help you streamline the process of adding assets like real estate to your portfolio as well as managing them long-term. To see how we can help, we invite you to schedule a complimentary meeting with us by calling 312-869-9394 or emailing steve@ctasira.com.
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*The content and opinions in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
**CTAS professionals are not financial advisors and cannot provide advice or recommendations regarding specific investment decisions.