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Beginner’s Guide For Using a Self-Directed IRA To Buy Real Estate

self-directed ira to buy real estate
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You can use an IRA to buy real estate when you establish a Self-Directed IRA through a passive custodian. Few retirement account holders realize that the Internal Revenue Code (IRC) allows for real estate (as well as many other alternative assets) to be held inside retirement accounts, such as an IRA or 401(k) plan. IRS rules permit individuals to engage in almost any type of real estate investment, aside from investments that involve a “disqualified person”.

So why do millions of Americans still not know that they can buy real estate with their retirement funds? The answer comes down to money. It is estimated that there is close to $28 trillion dollars in retirement funds, with the significant majority invested in traditional assets, such as stocks and mutual funds held at traditional banks and financial institutions.

Today, out of the roughly 52 million IRAs in the United States, estimates suggest that only 2 to 4 percent of them are self-directed. Basically, this means that almost 95 percent of Americans with Individual Retirement Accounts invest their retirement funds only in traditional, equity-type investments. However, if you want to purchase real-estate, cryptocurrency or other alternative assets, you need a self-directed IRA.

These banks and financial institutions make money when retirement account funds are invested in their financial products and keep your money there for a long time, whether through highly profitable trading commissions or by leveraging the power of your savings. They make no money when you use your money to invest in alternative or nontraditional investments such as a plot of land, cryptocurrencies, or private business. They get no commissions as a result. They lose access to your money, too. Why would they inform you, then, that such a strategy was permissible and possibly even preferable depending on the circumstances? Yet, social media has helped educate the millions of retirement account holders of the opportunity to use retirement funds to buy real estate or other alternative assets through a Self-Directed IRA.

Using a Self-Directed IRA to Buy Real Estate

Real estate is one of the most popular retirement investments among self-directed investors. One primary reason is that real estate is a tangible asset that produces steady income. For many investors, particularly those with real estate experience, it has been an integral investment in building retirement wealth. The investment may also appreciate in value, however this is dependent on the location of the land or property you purchased.

We cannot tell what the future will bring, and the threat of inflation looms over many investors, but the rise of inflation leads to the rise of rental income. As a result, your property will maintain, but most likely increase in value. This is why real estate investments act as a hedge against inflation.

The best way to purchase real estate is with a retirement account, however most banks and financial institutions will limit you to the products they sell, such as bank CDs, stocks, bonds, mutual funds, ETFs, etc. When using a Traditional IRA, it is unlikely to gain the freedom to invest in real estate even if you establish what financial institutions promote as a “self-directed” IRA. When you choose a Self-Directed IRA custodian (passive custodian) you will be able to invest in real estate assets you know and understand, such as rental property, multi-family property or a piece of land.

Related: Should I Cash Out My IRA to Buy Real Estate?

Self-Directed IRAs For Real Estate

You may have heard the term “Real Estate IRA.” A real-estate IRA refers to a self-directed IRA that primarily holds real-estate. Individuals can also hold other alternative assets, such as cryptocurrencies, precious metals, and tax liens. It can also be used for traditional investments, like stocks, bonds and mutual funds. However, individuals pursuing real-estate IRAs are frequently focus primarily on holding property to diversify their portfolios. A Real Estate IRA can hold pre-tax traditional IRA assets as well as Roth (after-tax). Alternative asset investments can be held directly by the IRA custodian or a via a limited liability company (LLC) which is known as “checkbook control.

There are many potential advantages of using retirement funds in a self-directed IRA to make alternative asset investments. The primary advantage of a self-directed real-estate IRA is the to generate tax-deferred or tax-free (when using a Roth IRA) income. The power to better diversify your retirement portfolio by investing in assets that you understand is another huge plus.

Pros and Cons of Self-Directed Real Estate IRAs

Individuals should be aware of the pros and cons of opening a self-directed real estate IRA. The potential benefits and limitations of using a self-directed real-estate IRA include:

  • Tax Benefits (Pro): While there are notable tax benefits of opening a self-directed real estate IRA, these benefits will be contingent on whether you open a traditional self-directed IRA or a self-directed Roth IRA.
  • Potential for returns (Pro): Real estate has the potential to offer another stream of capital.
  • Diversification (Pro): Investing in alterative assets, including real estate IRAs, will allow individuals to diversify their existing assets. Furthermore, self-directed IRAs can be used for more than just real-estate.
  • Checkbook Control (Pro): Individuals who open a self-directed IRA LLC can quickly access their funds by eliminating the need for a middleman.
  • Due Diligence (Con): Since self-directed IRAS have passive custodians, individuals need a better understanding of their investments.
  • Unrelated Business Income Tax (UBIT) (Con): Individuals need to understand how unrelated business income tax works and what steps they can pursue to avoid making prohibited transactions.
  • Liquid Capital (Con): Self-directed real estate IRAs can sometimes lack liquid capital when first established.

Buying Real Estate in Your Self-Directed IRA

Buying real estate in your IRA may not be for every retirement account holder. One needs to have sufficient funds in his or her IRA to be in a position to buy a piece of real estate. In addition, there are a number of other important items to consider before deciding:

1. Be Comfortable with the Investment

Real estate is generally a relatively large investment vis a vis the value of most Americans IRAs. Thus, it is important to make sure you have done your research and diligence on the real estate investment you are considering. It is good practice to look at multiple properties, research the market you are considering, speak to realtors or other real estate investors, and most importantly, be comfortable with allocating a sizable chunk of your retirement assets to a real estate investment property. As you will soon learn, you are not permitted to reside in the property, so don’t make your investment decision based on your personal preferences.

2. Understand the Economics of the Investment

It is important to have a good handle on the costs involved in owning the property. It is vital that you are realistic and objective when trying to learn the real numbers before closing. Look at previous years’ tax returns, property-tax bills, maintenance records, etc. to get a good idea of the real income and expenses. Also, it is important that you make sure to leave some extra funds in your IRA to cover any potential unforeseen property related expenses, since all expenses must be paid using IRA funds.

3. Understand the Prohibited Transaction Rules

The Internal Revenue Code (IRC) only states what one cannot invest in. IRC Sections 408 & 4975 prohibits “disqualified persons” from engaging in certain types of transactions. The definition of a “disqualified person” (Internal Revenue Code Section 4975(e)(2)) extends into a variety of related parties, but generally includes the IRA owner, any lineal descendants, such as parents, children, spouse, daughter/son-in law of the IRA holder, and entities in which the IRA holder holds a controlling equity or management interest.

4. Be Mindful of Using a Loan

If you will need to use a loan to close on your Self-Directed IRA real estate investment, only non-recourse financing may be used. A non-recourse loan is a loan that is not personally guaranteed by the IRA owner (the borrower) and whereby the lender’s only recourse is against the property and not against the borrower. However, when a Self-Directed IRA is investing in a real estate transaction involving the use of a non-recourse loan would be subject to tax pursuant to Internal Revenue Code Section 514, known as the Unrelated Business Taxable Income (UBTI). The tax rate could reach 37%.

Using a Self-Directed IRA to buy real estate has several advantages, although, it may not be for everyone. However, Self-Directed IRA investors wishing to use retirement funds to invest in real estate must be mindful of the four items outlined above and should consult with a tax professional for further guidance.

Get in Touch

If you have questions about using a Self-Directed IRA to purchase real estate, contact IRA Financial directly at 800-472-0646. You can also fill out our contact form to speak with a specialist.

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[10:44 PM] Valerie Marszalek-Boik