While there are many ways to invest in real estate, using a Self-Directed IRA can offer many benefits that other investment strategies cannot.

Though some people may shy away from this under-utilized investment tool because they don’t understand the many differences between IRAs, or perhaps their financial advisor steers them away since the advisor won’t collect fees, you can learn the advantages this strategy can offer for building your wealth.

What is a Self-Directed IRA?

Self-Directed IRAs allow you more choice where you invest your money while still having many protections that a traditional IRA offers. Some of the investment options include real estate, notes, precious metals, tax lien certificates, private placements and many others. Here we will focus on how to use one to invest in real estate.

Grow your Self-directed IRA Nest Eggs Money | Gary Lipsky Real Estate

A Self-Directed IRA can be deemed “traditional”, meaning contributions are tax-deductible in the year you made them, or it can be a “Roth” IRA which doesn’t provide an up-front tax deduction, but you won’t have to pay taxes in retirement at the time of withdrawal. Early withdraw penalties still apply if you need your funds before you reach the age of 59 ½ and count as ordinary income on your tax return. There are benefits to both, and you should strategize with your CPA and/or financial planner to decide which is best for your situation.

Getting Started with a Self-Directed IRA

There are many companies (like UdirectIRA or EquityTrust) that provide individual investors with the ability to set up self-directed retirement accounts. These companies act as the IRA Custodian which means they are responsible for record keeping and understand the IRS reporting requirements. They can provide much-needed guidance as you try to understand the oftentimes confusing rules of the IRS tax code.

Some IRA custodians have more complicated fee structures than others. Do your homework to decide which fee schedule is most advantageous for you. Be aware and keep in mind, if you plan to invest $25k, as an example, then you may need to put in around $26k to cover fees and maintenance costs until it generates enough cash flow to cover these expenses.

Why Buy Real Estate with Your IRA?

This is really two questions: First of all, you may want to read my blog post on six questions to answer before you invest in a real estate property. And secondly, as to why use your IRA as an investment vehicle for that rental, probably the biggest benefit of using a Self-Directed IRA to purchase real estate is due to the potential tax deferral-benefits discussed above. Active investors may buy, sell, or flip properties and move funds from one project to another while still maintaining the tax-deferred status of the traditional IRA. Additionally, another benefit of owning real estate in an IRA is the familiarity. Self-Directed IRAs provide you with an ability to participate in investments that you may know and understand, owning a home.

Furthermore, debt financing allows the IRA to borrow money from a bank or private lender to purchase property rather than having a loan in your name. An IRA can have even more borrowing power where, for example, an IRA with $50,000 can have the buying power of $150,000 or more. Leverage like this is seldom available with securities investments in IRAs, which is why Self-Directed IRAs provide so many benefits for retirement investors.

Are there any Risks?

One of the biggest risks of owning real estate in a Self-Directed IRA is the potential lack of diversification. Perhaps you focus only on upside potential in one part of the US. Ideally you would hold a range of real estate investment vehicles so that if any one area had a downside, it wouldn’t take down your whole IRA.

Liquidity is another concern when investing in real estate within an IRA. You may not be able to access the maximum value of your investment to make distributions immediately when you may need the money the most during your retirement years.

With a traditional IRA you must take required minimum distributions once you reach age 70 1/2. If you own real estate in an IRA, it is very difficult to sell off your real estate holdings in small chunks each year. That is the reason you must have enough cash in your IRA accounts to cover the required distributions and avoid tax problems.

What Are The Potential Tax Issues?

Owning real estate in an IRA allows your investment to grow on a tax-deferred basis or in the case of a Roth IRA, tax-free growth. However, if you don’t follow the rules and end up purchasing property the wrong way within an IRA, you could disqualify the IRA which creates a taxable event.

IRA ownership of investment property also loses some of the tax breaks available to real estate owners if the property operates at a loss. Similarly, you will not be able to claim depreciation on IRA-owned real estate.

Self-Directed IRA investment transactions must all be arm’s length transactions which means that no self-dealing, personal transactions or with immediate family members. So, you won’t be able to purchase a vacation home, primary or secondary residence unfortunately.

Some IRAs may have taxable income and need to pay taxes when assets are purchased with debt financing. This potential tax issue is called Unrelated Business Income Tax (UBIT) and occurs when you buy a property within your IRA using the leverage discussed above. For example, let’s say your IRA buys a rental property for $300,000 and that $100,000 came from the IRA and $200,000 came from a non-recourse loan. The property is thus 66% leveraged and as a result, 66% of the income is not a result of the IRAs investment but the result of the debt invested. Because of the debt, the IRS requires tax to be paid on 66% of the income. So, if there is $20K of rental income on the property then $13,200 would be Unrelated Debt-Financed Income (UDFI) and would be subject to UBIT payment. In this case, IRA owners may want to take advantage of the 1031 rules, and exchange their debt-financed property for another. The result of this exchange is that all or most of the IRA income taxes can be deferred.


My Story Using My IRA

I came across a real estate syndication deal that had all I looked for in a property but wanted to hold on to my cash for other purposes. Since I had some money in an IRA, I then transferred it into a Self-Directed IRA so I could invest in this exciting new opportunity. That transaction allowed me to learn by seeing how a bigger deal gets done while being able to own my small piece of a 400-bed student housing complex. I have since used this same strategy of a Self-Directed IRA to invest in other properties as well. I haven’t completed a full circle with the investment yet, but I believe strongly that I made the right decision and learned a lot that has been useful for all my future projects.

While investing in real estate with a Self-Directed IRA isn’t for everyone, hopefully this article gave you a good foundation in which to start your journey to financial freedom. You can also check out my article on my favorite real-estate-investing podcasters where you can hear more about this subject and others about growing your wealth through owning real property.

I love discussing anything to do with owning real estate, so contact me today!

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