Written by Rick Pendykoski – licensed financial advisor
Updated: MAY 6th 2020
What is a Real Estate IRA or Self-Directed IRA Real Estate?
A “Real Estate IRA” is a self-directed IRA, which primarily focuses on real estate investments. A Self-Directed Real Estate IRA allows you to invest your retirement funds in different types of real estate and real estate-related assets.
Types of Real Estate You Can Invest in With a Self-Directed IRA
- Mortgage Notes
- Offshore Real Estate
- Real Estate Owned Properties
- Apartment Buildings
- Building Bonds
- Commercial Paper
- Improved or Unimproved Land
- Joint Ventures
- Limited Liability Companies (LLCs)
- Limited Partnerships
- Tangible Asset Deeds
- Tax Lien Certificates
- Trust Deeds
The most common types of real estate found in self-directed IRAs are single-family homes and multi-family units. Rental income is generated by renting these properties.
Commercial property is another great way to generate long term rental income. The real estate investments include a broad range – from a grocery store, an office building to a baseball field.
Mortgage Notes are an indirect way to invest in real estate. You are a real estate lender who uses your savings to help others purchase homes while making a profit for yourself.
Offshore real estate investments are for investors who want the freedom to invest in foreign real estate markets and to take the tax benefits associated with overseas investments.
Real estate owned (REO) properties are foreclosed properties that have been taken back by the bank. You can use your self-directed IRA to buy these properties from the bank or the auctions.
Other real estate investments that are allowed with a Self-Directed IRA are:
How to Buy Real Estate With a Self-Directed IRA (SDIRA)?
Investing in alternative assets like real estate with your self-directed IRA is similar to a regular real estate purchase. However, there are certain rules and processes you need to follow to do it correctly. Here’s the process of buying real estate with a self-directed IRA:
- Open and fund an SD IRA account.
- Find a property to purchase.
- Direct your custodian to fund your investment with your account.
- Manage the investment in your account.
Use a qualified self-directed IRA custodian to do this.
Do your due diligence to identify the property you want to invest in.
Give the specifics of the property to your IRA custodian with information of how much money you need, if documents need signing and where to send the funds. You can either fund the entire purchase or a part of it with your IRA.
Since your IRA funded the investment, the money, income, and expenses, has to be to and from the IRA.
Funding Your Real Estate IRA Purchase
There are several ways you can invest in real estate with your IRA funds. Here are a few examples:
- Purchasing Directly
- Partnering With Other IRAs
- Establishing an LLC
- Insufficient Funds
Direct investment is the simplest and the quickest way to purchase real estate and collect the income generated from it within your self-directed IRA. Since your IRA pays for the investment, not you, but your IRA holds the title to the property. Prohibited transaction rules apply to direct real estate investments, so make sure you understand them to avoid tax penalties.
You can partner your IRA with your other IRAs. You can also bring in other investors to partner with your IRA with their IRAs or their personal funds. In this case, you have to divide the investment according to each investor’s contribution. Also, the profits and expenses for the investment have to be accordingly split among the investors.
In this, your IRA (not you) borrows money (non-recourse loan) to purchase a property, and the leveraged property is held in your IRA.
A limited liability company (LLC) is a business entity, which is used to purchase real estate using IRA assets as the funding source. The IRA holds an interest in the LLC, and the title of the property is held in the name of the LLC.
If there is not enough money in your IRA to cover the property expenses, you (the IRA holder) can choose to rent the property, make a contribution, transfer funds from another IRA, or liquidate other IRA assets to pay for the expenses.
Benefits of Using Self-Directed IRA to Purchase Real Estate
- Tax-Free or Tax-Deferred Earning
- Diversified Investment Portfolio
- Secure Future
- Easy to Get Started
- Transfer or rollover an existing retirement account, such as a 401(k), into a self-directed IRA.
- Make annual contributions to your account regularly.
- Start investing when you have collected enough to make an investment. If you don’t have enough cash to invest in real estate on your own, you can partner with other investors.
Although using your self-directed IRA to invest in real estate has many advantages, the exact benefit will depend on the type of account you use to invest. If you use a traditional self-directed IRA, your contributions/earning are tax-deferred, but your withdrawals are taxed. And if you use a self-directed Roth IRA, your contributions are taxed, but your earnings grow tax-free.
When you are investing through a self-directed IRA, you have a lot of real estate investment options. You can create a healthy level of investment diversification by choosing between rental properties (both residential and commercial), fix n’ flip opportunities, undeveloped land, mortgage notes, REITs, and many more.
Investments held in a self-directed IRA are more safeguarded from debt collectors. The rules also allow you to leave the savings to your heirs. So, a successful investment using your self-directed IRA could mean a secure future for you and a significant inheritance for your children.
All you need to do is open an account and fund it. You can fund your self-directed IRA in these ways:
Self-Directed IRA Rules for Real Estate
- Rule 1: You cannot own the property.
- Rule 2: The property must be uniquely titled.
- Rule 3: Do not take any indirect benefits.
- Rule 4: Purchase the property with a combination of funds.
- Rule 5: Pay for expenses from the IRA.
- Rule 6: If finance used, then pay UBIT.
- Rule 7: Income generated must return to IRA.
Your IRA cannot buy a property that you or a “disqualified person” owns. Also, your self-directed IRA cannot sell property to you or any disqualified person. The IRS considers these transactions as “self-dealing,” and such transactions are prohibited.
You and your IRA are two separate entities. Hence, investments made with your IRA should be titled in the name of your IRA.
If your IRA is involved in a transaction that somehow benefits you or a disqualified person, the IRS considers this as an “indirect benefit,” and that’s prohibited. An example of an indirect benefit is you renting the garage in a house that your IRA owns.
You can combine your SDIRA funds with your other funds to purchase real estate. Partnerships and undivided interest are two alternatives that exist.
Any IRA-owned property expenses, such as renovations, utility bills, property taxes, maintenance fees, and building association fees, have to be paid from your IRA.
If any of the IRA investments use financing, they are required to pay Unrelated Business Income Tax (UBIT).
Any income generated through self-directed IRA-owned property must be returned to your IRA.
Self-Directed IRA Risks & How to Avoid Them
- Risk 1: Not doing your homework
- Risk 2: Fraud
- Carefully verify the information for accuracy within each of your SDIRA statement.
- Do not entertain unsolicited investment offers.
- Ask questions. Be aware if someone hesitates to answer your questions.
- Run away from offers that say “Guaranteed returns.”
- Risk 3: Less real estate diversified portfolio
It is your responsibility to research the current real estate market trends, and analyze the potential of the property for future growth and increase in value before you decide to use your IRA to fund the purchase. If you are not an experienced real estate investor, seek the help of a trusted professional.
Ensure that you safeguard the money in your SDIRAs from fraud and fraudulent activities. Implement these strategies:
When in doubt, always seek professional help.
The key to a good investment strategy is diversification of assets. Investing in multiple versions of the same type of real estate can make you vulnerable to risks. So, consider liquidity and diversify your portfolio by investing in different types of real estate.
Self-Directed IRA Tax Pitfalls to Avoid
- If you are planning to purchase a vacation home, think again! With self-Directed IRA, you cannot be involved in self-dealing or carrying out personal transactions. Your family members, too, are prohibited from such kind of transactions. If you buy or sell a property from or to yourself or your family members, you’ll be creating a taxable event.
- Pay attention to Unrelated business income tax (UBIT) if you are thinking about using a mortgage to purchase the property.
- When you reach age 702½, you must take the required minimum distributions (RMDs) from your traditional IRA. If you are using your IRA money to invest in real estate, make sure you have enough cash left in your account to cover RMDs; otherwise, you’ll attract tax and penalties. Roth IRA’s are not subject to RMD’s and this is very important for estate planning.
Self-directed traditional IRA allows your investment to grow tax-deferred, whereas Roth IRA investments grow tax-free. However, you need to follow the rules while investing in real estate with your IRA. If the property is bought the wrong way, it can get your IRA disqualified, making you liable to pay taxes and penalties. If your IRA-owned investment property operates at a loss, you lose the tax benefits. Also, you cannot claim depreciation on IRA-owned real estate.