October 19, 2020

How To Invest in Real Estate with a Self-Directed IRA

Real estate investor holding a house key with a house keychain on it.

Real estate continues to be a popular topic, from house-flipping television shows to your friend renting out an apartment or a young couple moving into a house next door. This prevalence has led to real estate becoming one of the most popular alternative investments. Are you looking to get in on the action? Let's explore how to purchase real estate with a Self-Directed IRA.

Can I Invest in Real Estate With an IRA?

Yes! Most IRA account holders assume that an IRA can only invest in the usual suspects of stocks, bonds, and mutual funds. The reason for this is that these assets are the only options available to them at brokerages. However, you can use a Self-Directed IRA to invest in real estate and a variety of other alternative assets as well, including private placements, and tax liens.

What Are the Self-Directed IRA Rules for Real Estate?

The most important rule is to always think of your IRA and personal funds as two separate entities. Technically, the IRA owns the property, and you, as the account holder, are the manager. Think of it as if your IRA is a company, like Amazon. When you invest in Amazon, Jeff Bezos is responsible for all cash-flow decisions. With a Self-Directed IRA, you are the manager who is responsible for all decisions and transactions. However, you cannot receive a material benefit from your IRA asset. This would be called a prohibited transaction. The good news is that once you get the rule down, it's really easy to stay in compliance.

Pros and Cons of Self-Directed IRA Real Estate Investments

Now that you understand what a Self-Directed Real Estate IRA is, you need to also understand its many facets. There's a lot to take into consideration when it comes to a Self-Directed IRA and real estate, like depreciation, portfolio diversification, and deferred taxes, just to name a few.

  • Diversification: Each asset reacts differently to the same event. Therefore, to minimize risk, investors should purchase a variety of assets. This does not prevent loss or promise gains, but it can aid you in accomplishing long-term financial goals. 
  • Steady Income: Unlike the volatile stock market that fluctuates quite often and has the ability to crash, real estate usually retains its value. That's not to say that when mixing a Self-Directed IRA and real estate, depreciation doesn't occur, but property value does not fluctuate as much as stock prices.
  • Tangible: Real estate is a tangible asset that can never lose all of its value, unlike stocks. Even if the real estate market value were to decrease, you will still have the physical property that can be sold.  
  • Deferred Taxes: As with any Traditional IRA investment, the profit generated is tax-deferred until you take a withdrawal. If it's a Roth IRA, profits accumulate tax-free. Active real estate investors may buy, sell, or flip properties while maintaining the tax deferral status of the IRA.
  • A lot to Manage: Depending on your type of real estate investment, managing the property may take a lot of your time. From fixing issues that arise such as the plumbing leaking to paying the electricity bills, a real estate investment can be time-consuming.
  • Rent Controls: If you are investing in rental units, there’s a possibility that the local government may impose rental controls, which are limits to what you can charge as rental rates to your tenants.
  • UBIT/UDFI: When investing in real estate, it’s important to keep UBIT or Unrelated Business Income Tax, and UDFI, or Unrelated Debt Financed Income in mind. UBIT is a tax that applies to your gains if you are running an active business out of your IRA. UDFI, is a tax that applies to any income you earn from purchasing an investment with borrowed money, such as a non-recourse loan.

Although there are several benefits, there are both pros and cons of Self-Directed IRA real estate investments to consider. This means that even if you know how to use a Self-Directed IRA for real estate, it may not be the right asset for everyone to invest in. It is important to do your due diligence and speak to a financial professional to see if this investment option is right for you. Investors should also be familiar with the Self-Directed IRA rules and have enough funds in their account to purchase the property and pay all other expenses. (And don't forget that IRAs have a contribution limit each year!)

How to Use a Self-Directed IRA for Real Estate Investing

After doing your due diligence and deciding to invest, you need to understand how to invest in real estate with a Self-Directed IRA. This is a quick process, but there are a few required steps. Let's use the example of Jonah, who is interested in using his Roth IRA funds to buy a property. 

Step 1: Create a Self-Directed IRA

Jonah has been researching and speaking to his financial advisor about the advantages/disadvantages of owning real estate in a Self-Directed IRA. He reads about prohibited transactions to make sure he is following the IRS's rules. After conducting research, he decides to open a Self-Directed Roth IRA with a custodian who is willing to answer all of his questions and is knowledgeable about the real estate investing process.

Step 2: Transfer Funds Into the Self-Directed IRA

Since Jonah already has a standard Roth IRA, he is able to transfer the desired amount of funds from that into his new Self-Directed Roth IRA.

Step 3: Establish an IRA LLC, If Applicable

Jonah is aware that a Self-Directed IRA must be held by a regulated custodian but recognizes the option to have checkbook control by opening a Self-Directed IRA LLC. He chooses the checkbook control model because he wants to be able to handle all cash flow transactions in real-time, without having to contact his custodian first. This saves him both time and money. 

Jonah creates a Self-Directed IRA LLC checking account at his local bank, and his custodian moves his funds there.

Step 4: Invest in the Property of Your Choice

Jonah purchases a property in a beautiful location that fits his budget. He has enough funds in his Self-Directed IRA to purchase 100% of the investment, making him the sole owner of the property and the manager of all IRA transactions.

Ongoing Maintenance

All rental income and expenses are handled through the IRA checking account. The rental checks keep coming in, and Jonah's retirement account continues to grow. Since he has a Roth IRA, the profit earned is tax-free. Jonah is happy with his investment and is thinking about purchasing a second property in the near future.

Key Takeaways for Using a Self-Directed IRA to Invest in Real Estate

If you've ever wondered, "Can a Self-Directed IRA purchase real estate?" the answer is yes. Using a Self-Directed IRA to purchase real estate is a great way to diversify your portfolio and have protection against economic fluctuations, all within a tax-advantaged retirement account. However, before creating an account and investing, be sure to do your due diligence and discuss with a financial professional if this investment is right for you. You may also speak to a Self-Directed IRA Specialist about any questions involving the investment process.


Still have questions about your investment?

Still have questions about your investment?
Corporate Headquarters:
Madison Trust Company 401 East 8th Street • Suite 200
Sioux Falls, SD 57103
Mailing Address:
Madison Administration Company One Paragon Drive • Suite 275
Montvale, NJ 07645
Hours:
Monday - Thursday: 9:30AM - 5:30PM EST
Friday: 10:00AM - 4:00PM EST
Saturday/Sunday: Closed
Contact:
(800) 721-4900
[email protected]
F: 845-947-1212
magnifiermenuchevron-down