Can I Invest in Real Estate with my IRA?
You can make real estate investments with your IRA. In fact, the IRS has always allowed investors to hold real estate in their retirement account, yet many investors use their IRA to invest in bank CDs, the stock market or other traditional assets. This is because banks and traditional financial institutions limit their clients to the financial products they sell, which does not include alternative assets, like real estate. When you establish a Self-Directed IRA through an IRA custodian, you have the freedom to invest in real estate and other alternative investments along with traditional investments. The Self-Directed IRA structure is perfectly legal. It is similar to a Traditional IRA but allows you to diversify your retirement investments so they do not move in the same direction. The IRS permits you to engage in virtually any type of real estate investment as long as it does not include a disqualified person, such as yourself and lineal descendants.
Read More: How Do Self-Directed IRAs Work
- One can use IRA funds to invest in alternative assets, including real estate
- Real Estate remains the number one alternative investment among retirement investors
- You should be aware of the IRS rules before investing
Self-Directed IRA for Real Estate
A Self-Directed IRA through a passive custodian is a traditional IRA that allows you to make IRS approved investments using your retirement funds. Investments you can purchase with a Self-Directed IRA include alternative assets, such as real estate. Some refer to a Self-Directed IRA for real estate as a “real estate IRA.” Although a real-estate IRA is a Self-Directed IRA, the investor primarily holds real-estate in his or her portfolio. However, Self-Directed IRAs allow you to invest in a wide range of alternative investments including gold, cryptocurrencies, private placements, and more. Furthermore, not all Self-Directed IRAs allow individuals to invest in real estate. Instead, some offer limited options, allowing IRA holders to only purchase cryptocurrencies and gold. Hence, if you are interested in investing in real estate, it is important to find a Self-Directed custodian, like IRA Financial that gives you an extensive range of alternative investment opportunities.
As with a Traditional IRA, all investments are either tax-deferred or tax-exempt with a Self-Directed IRA. Tax-deferral essentially means you do not have to pay taxes immediately. You can pay at a later date and allow the investment to grow unhindered until you take a qualified distribution.
Let us take a look at the power of tax-deferral when investing with a retirement plan. Assume you establish your retirement plan with $100,000 and you keep it open for 20 years. If you generate an average annual pretax rate return of 8% and the average tax rate is 25%, your investment will be worth $466,098 after 20 years. After taxes, you receive $349,572 on the earnings. Over the years, your investment compounds by re-investing your original investment.
Ideally, you should begin real estate investing when you are earning higher income and in a higher tax bracket. That way, when you reach retirement age and you can take a distribution, you most likely earn less income or no income, therefore in a lower tax bracket. In other words, you take more money home.
Learn More: How to Fund a Self-Directed IRA Rollover
Two ways to buy a home with a Self-Directed Real Estate IRA
A Self-Directed IRA offers an investor more investment options than a financial institution Self-Directed IRA. IRA Financial Trust, a regulated trust company, will serve as the custodian of the IRA. Unlike a typical financial institution, IRA Financial generates fees simply by opening and maintaining IRA accounts and does not offer any financial investment products or platforms. The IRA funds are held with IRA Financial Trust and, at the IRA holder’s direction, will invest the funds into alternative asset investments, such as real estate.
Self-Directed IRA LLC
The Self-Directed IRA LLC with “checkbook control” has quickly become the most popular vehicle for investors looking to make alternative assets investments, such as rental real estate, that require a high frequency of transactions. Under the Checkbook IRA format, a limited liability company (“LLC”) is created which is funded and owned by the IRA and managed by the IRA holder. The “checkbook control” Self-Directed IRA allows one to eliminate certain costs and delays often associated with using a full -service IRA custodian. The Checkbook IRA LLC structure allows the investor to act quickly when the right investment opportunity presents itself cost effectively and without delay.
Why Buy a House with a Self-Directed Real Estate IRA?
There are many reasons people want to buy a house with their retirement account. The first is diversification. Gaining the ability to diversify your retirement assets and invest in assets other than equities is a great way to build a well-rounded retirement portfolio. Second, gain the ability to invest in an asset you know and trust. Many investors have more confidence in investing in real estate, an asset they understand, versus stocks or mutual funds. Third, invest in an asset that can generate cash flow as well as benefit from appreciation. Fourth, real estate is a hard asset and is considered a smart hedge against inflation.
What Real Estate Investments Can I Make with a Self-Directed IRA?
Below is a partial list of domestic or foreign real estate-related investments you can make with a Self-Directed IRA:
- Raw land
- Residential homes
- Commercial property
- Condos/town homes
- Rental properties
- Mobile homes
- Real estate notes
- Real estate purchase options
- Tax liens certificates
- Tax deeds
Learn More: Real Estate Investing
Investing in Real Estate with an IRA LLC is quick and easy. When you see an investment you want, simply write a check, wire the funds or use a debit card. It is essentially the same as purchasing real estate personally, but with the added benefit of tax-deferral.
While you may open real estate IRA with retirement funds, IRA Financial Group does prevent you from investing in other alternative and traditional investments. It is important to note that some Self-Directed IRA custodians only allow you to invest in certain alternative investments.
Read More: What Can I Invest in with a Self-Directed IRA?
Get Started in Real Estate Investing
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.
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.”
Did you know that you can flip homes in your Self-Directed real estate IRA?
Learn More: Self Directed IRA to Flip Homes Tax Free
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.”
How to Buy Real Estate in an IRA
With IRA Financial Group you can easily and quickly establish your Self-Directed IRA/IRA LLC to make real estate investments. It only takes five steps.
- Identify the investment property.
- Purchase the investment property with the Self-Directed IRA LLC – no need to seek the consent of the custodian with a Self-Directed IRA LLC with “Checkbook Control”.
- Title to the investment property and all transaction documents must be in the name of the Self-Directed IRA LLC. The LLC manager must sign pertaining to the property investment.
- All expenses paid from the investment property go through the Self-Directed IRA LLC. Likewise, all rental income checks must be deposited directly into the Self-Directed IRA LLC bank account. Do not depot IRA related investment checks into your personal accounts.
- All income or gains from the investment flow to the IRA tax-free!
Advantages of a Self-Directed IRA LLC to Purchase 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.
Tips for Buying a House with a Self-Directed Real Estate IRA
Do your Diligence
Do your homework before you buy a home with a Self-Directed Real Estate IRA. This is especially true for real estate located in a state you do not reside in and especially real estate located outside of the country. Thankfully with the internet you can learn a significant amount a piece of real estate and the surrounding neighborhood. Ass any good real estate investor and they will tell you that money is made on the purchase of real estate and not the sale.
Understand the Numbers
As with every investment, investors should make sure that they understand and have evaluated the economic merits of the investment, as well as the potential financial obligations surrounding the investment. For example, if one is contemplating purchasing real estate with a Self-Directed retirement account, it is important to verify that there are sufficient funds in the IRA to cover the purchase price. In addition, it is imperative that the investor consider any potential expenses, such as improvements, taxes, etc., that are likely to arise while owning the investment as only retirement account funds can be used to pay for such costs
Savvy Strategies for Using Your Self-Directed IRA to Purchase Real Estate
When using a Self-Directed IRA LLC to make a real estate investment, there are a number of ways you can structure the transaction:
1. Use your Self-Directed IRA LLC funds to make 100% of the investment
If you have enough funds in your Self-Directed IRA LLC to cover the entire real estate purchase (including closing costs, taxes, fees, insurance, etc.) you may make the purchase outright using your Self-Directed IRA LLC. You pay all ongoing expenses relating to the real estate investment out of your Self-Directed IRA LLC bank account. All income or gains relating to your real estate investment must return to your Self-Directed IRA LLC bank account.
Learn More: What is a Self-Directed IRA LLC?
2. Partner with family, friends, colleagues
If you don’t have sufficient funds in your Self-Directed IRA LLC to make a real estate purchase outright, your Self-Directed IRA LLC can purchase an interest in the property along with a family member who is a non-disqualified person. You can also purchase with a friend, or colleague. The investment will not be made into an entity owned by the IRA owner. Instead, it’s invested directly into the property.
For example, your Self-Directed IRA LLC can partner with a non-disqualified family member, friend, or colleague to purchase a piece of property for $150,000. Your Self-Directed IRA LLC can purchase an interest in the property (for example, 50% for $75,000) and your family member, friend, or colleague can purchase the remaining interest (50% for $75,000).
All income or gain from the property will allocate to the parties in relation to their percentage of ownership in the property. Likewise, all property expenses must be paid in relation to the parties’ percentage of ownership in the property.
Based on the above example, for a $2,000 property tax bill, the Self-Directed IRA LLC will be responsible for 50% of the bill ($1,000). The family member, friend, or colleague is then responsible for the remaining $1,000 (50%).
We’ll discuss more on partnering with family, friends and colleagues later in this article.
3. Borrow money for your Self-Directed IRA LLC
One question we are frequently asked is, “Can an IRA get a mortgage or loan?” A real estate IRA or Self-Directed IRA can absolutely get a loan. The process of qualifying for a loan inside an IRA is called non-recourse financing. Before considering non-recourse financing, there are few options you need to consider:
1. If the IRA purchases real estate and secures a mortgage for the purchase, the loan must be non-recourse. Otherwise there will be a prohibited transaction. A non-recourse loan only uses the property for collateral. In the event of default, the lender can collect only the property and cannot go after the IRA itself.
2. Tax is due on profits from leveraged real estate. If your Self-Directed IRA LLC uses non-recourse debt financing (i.e., a loan) on a real estate investment, some portion of each item of gross income from the property are subject to Unrelated Business Income Tax (UBTI). This is pursuant to Code Section 514. “Debt-financed property” refers to borrowing money to purchase the real estate. For example, a leveraged asset that is held to produce income.
In such cases, only the income attributable to the financed portion of the property is taxed. Gain on the profit from the sale of the leveraged assets is also UDFI. However, it is not Unrelated Debt Financing tax (UDFI) if the debt is paid off more than 12 months before the property is sold.
Learn More: Non-Recourse Financing
There are some important exceptions from UBTI. Those exceptions relate to the central importance of investment in real estate from the sale of real estate. This includes:
- Most rentals from real estate
However, rental income the real estate generates that is “debt financed” loses the exclusion. That portion of the income becomes subject to UBTI. Thus, if the IRA borrows money to finance the purchase of real estate, the portion of the rental income attributable to that debt will be taxable as UBTI.
Let’s assume the average acquisition indebtedness is $50: the average adjusted basis is $100. 50 percent of each item of gross income from the property is included in UBTI.
Did you know: If you invest in real estate with a Solo 401(k), you can obtain a mortgage or loan without trigger UBTI?
Learn More: Real Estate Investments with a Solo 401(k)
UBTI Tax Rates
In most cases, when you use a retirement plan to make investments, you do not generate tax in the case of a Roth IRA, or the taxes will be deferred until a distribution, such as a Traditional or Self-Directed IRA. However, there are certain instances where you will trigger a tax known as the Unrelated Business Taxable Income (UBTI) tax. If you use retirement funds in a real estate transaction that involves a non-recourse loan, you will trigger the UBTI tax. In that case, it’s important to note that a Self-Directed IRA LLC subject to UBTI is taxed at the trust tax rate. This is because an IRA is considered a trust. For 2023, a Self-Directed IRA LLC subject to UBTI is taxed at the following rates:
- $0 – $2,550 = 10% of taxable income
- $2,551 – $9,150 = $255 + 24% of the amount over $2,550
- $9,151 – $12,500 = $1,839 + 35% of the amount over $9,150
- $12,501 + = $3,011.50 + 37% of the amount over $12,500
Partnering with a Family Member in a Real Estate Transaction – Prohibited Transaction?
Partnering with a family member is likely not prohibited if the transaction is structured correctly. Investing in an investment entity with a family member and investing in an investment property directly are two different transaction structures that impact whether the transaction will be prohibited under Code Section 4975.
The different tax treatment is based on who currently owns the investment. Using a Self-Directed IRA LLC to invest in an entity that a family member owns (and is a disqualified person) will likely be treated as a prohibited transaction.
However, partnering with a family member that is a non-disqualified person directly into an investment property is likely not a prohibited transaction. It’s important note that if you, a family member, or other disqualified person already owns a property, then investing in that property with your Self-Directed IRA LLC would be prohibited.
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).
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.