Getting started in real estate investing requires expertise, background knowledge and motivation. The level of each will vary whether you choose to make direct or indirect real estate investments. You have the option of using personal funds and retirement funds when making a real estate investment. When you use a retirement plan, such as the Self-Directed IRA, tax on the investments will be deferred or completely eliminated in the case of a Self-Directed Roth IRA.
We’ll explain what direct and indirect investing entails to help you determine the best approach and how to get started with a Self-Directed IRA.
Get Started in Real Estate Investing
Many of us are aware of the financial perks that come with real estate investing. The ability to gain a steady cash flow through rental income and its financial security makes it an attractive investment opportunity. During times of inflation, real estate thrives through increased property value and the rise of rental income while the value of many other investments erode.
Whether you see real estate investing as a means to quit your 9-5 and go into business for yourself, or to supplement your current job, it is an opportunity to generate higher, more predictable returns and have more control over the investment than other asset classes, such as stock.
If you are an investor who wants to get started in real estate investing, you can directly purchase real estate or indirectly invest in real estate properties.
Direct vs Indirect Real Estate Investing
Direct real estate investments generally involve purchasing a stake in individual properties for the purpose of flipping the property or renting it out. Indirect real estate investing generally involves buying shares in a real estate related project.
As a general rule, indirect real estate investing is far more passive, according to Brian Davis, Director of Education at Spark Rental. However, retirement investors will have far less control over the investment(s).
“(You) can’t predict returns the same way you can with direct real estate investments,” says Davis.
Retirement investors who want to invest directly in rental properties must have the knowledge to form the following plans:
- Finding the property
- Verifying that it is a good deal
- Financing the property
- Managing the property
“Those plans don’t have to be complicated,” says Davis. He recommends simplifying the process in the beginning and then increase the complexity once you gain more confidence and expertise.
“You don’t need to run ragged contacting every homeowner in foreclosure in your market,” says Davis. “You can start with properties listed on the MLS, or on Roofstock, or properties offered by local wholesalers or turnkey sellers.”
Analyze the Property
“One area where I feel many new investors fall short, however, is analyzing properties and forecasting cash flow,” says Davis.
Location is a good place to start when analyzing property. New investors should look for properties in a high demand location that can generate high cash flow. It’s also important to perform basic calculations on the property prior to making a purchase. While performing calculations does not guarantee a high rate of return, there are considerable costs associated with real estate investing. As a result, it is an integral step prior to making the investment.
“(Spark Rental) feels so strongly about making sure that new investors get this right that we moved our rental income calculator from behind a paywall to make it free, so people could accurately forecast cash flow,” says Davis.
Put in the Work
Direct rental investing is not difficult, but Davis stresses the importance of discipline, hard work and motivation. However, it is not for everyone. Retirement investors must have a strong interest in learning real estate investing.
“I would only recommend (direct real estate investing) for people actively interested in learning real estate investing,” Davis explains. “(Direct real estate investing) requires some specialized knowledge that investors must go out and learn on their own.”
Real estate will make an attractive addition to anyone’s investment portfolio. However, investors must be prepared to put in the work.
“The more you’re willing to learn, the better your returns will be, and the less likely you are to make expensive mistakes.”
Retirement investors who do not feel equipped for the rigors of direct real estate investing can invest indirectly through REITs (real estate investment trusts), crowdfunding websites, private notes or through a silent partnership.
“There’s less of a learning curve with these indirect investments, and often more liquidity, so it feels less daunting for new investors to get started,” Davis says.
When indirectly investing, the level of real estate background knowledge required depends on the type of indirect investment you choose. For example, investing in a REIT vs. going through a crowdfunding platform has different degrees of expertise.
“When you invest in a REIT, it helps to have some knowledge of how to analyze ETFs or mutual funds, but it’s not required,” says Davis. “Likewise, it takes no knowledge to invest in a crowdfunding website’s private REIT.”
Self-Direct Your Real Estate Investments
Whether you make the decision to get started in real estate investing directly or indirectly, the best way to invest is with an IRA or 401(k) retirement plan, as it will offer tax advantages. Like a traditional IRA, a Self-Directed IRA allows your investment to grow tax-deferred until you make a qualified distribution. As a result, the income your investment generates will be free to grow unhindered. Generally, all investments are tax-free (Roth) or tax-deferred (Pre-tax). However, in the case of real estate investments with a Self-Directed IRA, there is a tax called UBIT to consider.
UBIT tax can apply if sales of the real estate property are frequent, as it may be considered a trade or business that is regularly carried on. UBIT also applies when an investor uses a nonrecourse loan to purchase some of the property, which will result in tax on the debt-financed portion of the property.
Investors who are self-employed or a small business owner with no full-time employees can establish a Solo 401(k) plan. The Solo 401(k) plan is a more attractive retirement plan for investors who wish to purchase real estate, as it is not subject to the UBIT tax laws.