Diversification is key to a healthy retirement account, and for many investors, real estate is a promising asset that offers stability and high growth potential.

Diversification is crucial for a healthy retirement account. For many investors, real estate is an appealing asset offering stability and high growth potential.

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Real estate is an excellent self-directed IRA investment that often yields better returns when compared to more traditional assets, such as mutual funds or stocks. Best of all, real estate can generate a passive income, facilitating consistent growth.

If you’re ready to add real estate to your retirement portfolio, you’ll need to establish a real estate self-directed IRA before making your first investment. 

Here’s everything you need to know about a real estate self-directed IRA.

How to Invest in Real Estate with an IRA

While you can invest in some forms of real estate stock with a Traditional IRA, you’ll need to open up a self-directed IRA to physically buy properties. Here are the differences between both types of accounts.

Traditional IRA

Traditional IRAs allow you to invest in real estate via Real Estate Investment Trusts (REITs) or publicly traded companies that own and operate all kinds of properties, from single-family homes to skyscrapers. Investing in REITs allows you to gain exposure by purchasing shares in these companies, which typically pay dividends.

It’s important to note that when investing in REITs, you don’t have direct ownership of any specific real estate property. Rather than owning property directly, you’re investing in the companies that manage these properties. 

Self-Directed IRA (SDIRA)

SDIRAs enable you to directly invest in real estate with partial or full ownership while enjoying various tax advantages. 

Unlike REITs, which mainly generate income via dividends, SDIRAs allow you to earn direct income from selling or managing a property. Therefore, if you purchase property with an SDIRA, you will assume all of the responsibilities of managing that property, from evicting tenants to purchasing improvements. 

Some of the most common types of real estate investing strategies available to SDIRA holders include:

  • Rental property management
  • Home flipping
  • Wholesaling
  • Tax lien investment

Thanks to the tax benefits of a Roth SDIRA, you will never pay a dime on your earnings. Traditional SDIRAs are taxed upon withdrawal but can be invested fully with pre-tax dollars. 

There is one caveat to purchasing homes with an SDIRA. Due to the tax benefits of an IRA, the IRS does restrict certain transactions that may benefit you or other disqualified persons to prevent tax avoidance (more below).

 

Consult with Horizon Trust

Types of Real Estate You Can Invest In with a Self-Directed IRA

In general, you can use your self-directed IRA to purchase most types of real estate, including but not limited to the following:

  • Residential Properties 
  • Commercial Properties
  • Raw Land
  • Vacant Lots
  • Tax Lien Certificates
  • Mobile Homes and RV Parks
  • Self-Storage Units
  • Real Estate Limited Partnerships
  • International Real Estate
  • Real Estate Development
  • Partnerships
  • Rental Properties
  • Commercial Leaseholds
  • Real Estate Notes and Mortgages

The Pros and Cons of Buying Real Estate with an IRA

Pros

  • Tax Benefits. SDIRAs enjoy the same tax benefits as ordinary IRAs. If you choose a Traditional SDIRA, you can purchase real estate using pre-taxed dollars, and your investment will grow tax-deferred, with taxes applied only upon distribution. If you choose a Roth SDIRA, you invest with previously taxed funds but will not need to pay taxes on distributions. This can provide a tax shelter for individuals who believe they will be in a higher income bracket upon retirement.
  • Enhanced Investment Control. When you use an SDIRA to purchase real estate or any alternative asset, you gain direct control over how your funds are invested. This benefit gives you the control to add various property types to your portfolio, including commercial or residential rental properties. You also maintain the ability to sell or flip the property and return any earnings to your IRA to grow your account or purchase other properties.
  • Potential for Increased Returns. Real Estate ROIs can be realized in two primary ways: income earned from rental properties or equity earned when you sell your property. Depending on your real estate market knowledge, SDIRA real estate investments can yield significantly higher returns than more traditional assets, like mutual or index funds.
  • Asset Protection. Other assets may be vulnerable if you claim bankruptcy, but your IRA is typically safe. Under the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA), assets held in IRAs, including traditional, Roth, and SDIRAs, are protected by up to $1 million in the event of bankruptcy.

Cons

  • Additional Rules and Regulations. When you use your SDIRA to invest in real estate, specific rules dictate how to use and engage with your property. One of the primary rules is that the property you purchase with your IRA must be used only as an investment. You cannot live in or use the property for work, such as office space. In addition, any earnings you make off the property, including rental income, must be returned directly to your IRA account. 
  • Disqualified Persons: The same rules apply to disqualified persons, which include your parents, spouse, children, grandchildren, grandparents, or the spouse of a decedent (e.g., a child’s spouse would be considered a disqualified person).  If you fail to follow real estate investment rules, you risk engaging in a prohibited transaction with tax penalties.
  • Additional Paperwork and Fees. SDIRAs and related transactions come with more paperwork and fees than a regular IRA account. That’s why it’s essential to thoroughly vet and compare custodians (the entity in charge of holding funds and overseeing transactions). The right custodian offers fee transparency and is well-versed in the paperwork and forms required for the alternative asset you’re interested in—real estate, in this case.
  • Increased Vetting & Responsibility Required. When you invest in real estate through your IRA, you must perform due diligence and determine what is (or isn’t) a good investment. This won’t be a drawback if you’re well-versed in the real estate market and related issues. On the other hand, if you’re new to the game, it’s important to remember that your SDIRA custodian only acts as an administrative third party regarding investment advice. They won’t provide any insights into the stability or risks involved with a specific investment.
  • Potential UBTI Obligations. In most cases, you only need to worry about taxes when you take a distribution (traditional IRAs) before contributing (Roth IRAs) or taking non-qualified withdrawals from your account. However, in some cases, earnings from your real estate investment may be considered unrelated business taxable income (UBTI), and you’ll be on the hook for taxes. If you’re investing in real estate, discuss the tax implications with a tax advisor or a qualified custodian who can help determine if you’ll be subject to UBTI obligations.

Real Estate Self-Directed IRA Rules and Limitations

If you purchase real estate with an IRA, there are specific rules and limitations to remember:

  1. You cannot use an IRA to purchase a property you intend to permanently or temporarily live in.
  2. You cannot use IRA funds to purchase a lot to build a structure, residential or dwelling, in which you plan to live or use as a place of business.
  3. If purchasing a home or other structure to “flip,” you must hire an outside contractor to complete the work. You (or any disqualified person) cannot complete renovations or other work required.
  4. Any income you receive from the property, including rental or equity from a property sale, must go back to the IRA account—you cannot live off of earned income from the property.
  5. You cannot pay yourself with funds from your IRA or those earned from your IRA-purchased property.
  6. If using IRA funds to invest in real estate, you cannot purchase property from a disqualified individual, such as a family member.

Before you use your IRA to invest in property, familiarize yourself with all IRS rules and regulations to avoid engaging in prohibited transactions, which will result in penalties and jeopardize your retirement savings.

How to Purchase Property with a Self-Directed IRA

Find an SDIRA Custodian

To purchase property with an IRA, you must first open a self-directed IRA account with a real estate IRA custodian. Banks often offer IRAs and other retirement products but only occasionally provide self-directed IRAs.

Finding the proper custodian is one of the most important steps to ensure you can execute your retirement strategy.

Find and Plan for a Property Purchase

Once you open your SDIRA account with a qualified custodian, you can begin your hunt for real estate. As mentioned earlier, IRA funds can be used to purchase various types of commercial and residential property, including lots and raw land.

Remember that you cannot purchase property from a disqualified person or complete any work or renovations yourself. You’ll need to hire someone to do the work for you. It’s essential to be aware of these limitations when looking for the right property, especially if your goal is to flip the property and make a profit.

Fund Your Purchase

You can fund your IRA real estate purchase using one of four methods:

Cash Purchase

If you have enough money in your IRA account, you can use it to buy the property outright. We highly recommend cash purchases, as you won’t need to worry about a mortgage or unnecessary taxes.

Partner with Another Investor

If you don’t have enough funds in your SDIRA, you can partner with another SDIRA account holder, such as a spouse, friend, or business partner, to combine funds and purchase the property. Under this arrangement, you would own a percentage of the property. Property expenses and earnings would then be divided according to the ownership agreement.

Finance Your Purchase

If you want to buy a real estate property without the required funds, you can borrow against your IRA to complete the purchase. Under this arrangement, the mortgage is extended to your IRA, not you, and the property is used as collateral.

This option is typically accessible for individuals purchasing income-earning properties, such as rental properties, as the IRA is responsible for repaying the debt, and lenders prefer applicants who can demonstrate a track record of repayment. Financing will also typically require a significant down payment (40% to 50%), resulting in UBIT obligations.

Form an SDIRA LLC

If you have enough funds, you can form an LLC and direct your custodian to move funds from the investment account to the LLC. Commonly referred to as checkbook control, this type of arrangement increases control and allows you to purchase and pay related expenses directly through the LLC, with limited dependence on the custodian.

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Bypassing Your Custodian with Checkbook Control

One of the best ways to gain greater control over your SDIRA is bypassing your custodian with checkbook control. Checkbook control prevents custodial approval for select transactions, especially when investing in alternative assets like cryptocurrency, precious metals, and tax liens.

The first step to bypassing your custodian with checkbook control is establishing a checkbook LLC and adding your Self-Directed IRA as a member. From there, open an LLC-backed bank account and use it to conduct your transactions.

Beyond greater control of your investments, checkbook control enables faster decision-making (great for urgent investment opportunities), eliminates administrative costs, better diversifies your portfolio, and protects your retirement investments from personal liability.

If you’re interested in checkbook control to help you streamline your investment process, consult Horizon Trust or a trusted financial professional to walk you through the process.

Managing and Selling a Property in Your IRA

Once you purchase your property, the next step is to decide how you will manage the property. Managing your IRA-purchased property is subject to similar regulations and limitations that apply to the purchase and use of the property. For example, the account holder or disqualified persons cannot manage rental income and expenses.

Here are three considerations on how to manage and sell a property in your IRA:

Rent Paid to the LLC

If you are collecting rent, the rent must be paid directly to the IRA, not deposited into your bank account, and then deposited into the IRA. The most common management structure is through an LLC. Money flows in and out of the LLC checking account. For instance, the account owner can cover related expenses using the LLC checking account, and rent is paid to the LLC and distributed back to the IRA.

Hiring a Property Manager

Another option is to hire a property manager through the IRA. In this situation, the property manager is responsible for renting or leasing the property and managing related expenses. The property manager will then remit income to the IRA, minus fees or other expenses.

Management through the IRA

In this scenario, the custodian receives funds and pays expenses directly from the IRA.

If you choose to sell the property, you must work directly with the custodian and a real estate agent to complete the sale. The IRA acts as the “seller” in the real estate transaction. All earnings from the sale must be deposited directly to the IRA. Property sales are held to the same rules and regulations, particularly regarding disqualified individuals. In this case, you cannot sell the property to a disqualified individual, such as yourself, a spouse, or a family member.

FAQs

What are the tax implications of owning real estate in an IRA?

There are several tax implications to owning real estate in an IRA (not an all-inclusive list):

Tax-Deferred Growth: Any income and capital gains will not be immediately taxed when holding real estate in an IRA. Instead, it will continue to compound tax-free until it is withdrawn upon retirement, with penalties assessed for early withdrawals.

Prohibited Transactions: Using your real estate asset for personal use or self-dealing will result in severe consequences, including the loss of your tax advantage status and penalties and administrative hassles. Ensure you fully understand all IRS rules regarding prohibited transactions before engaging.

Unrelated Business Tax (UBIT): You may be subject to unrelated business tax if you engage in a trade or business generating income unrelated to real estate transactions within your IRA. These activities may include operating a store or leasing a brick-and-mortar location.

Always be mindful of the tax implications of owning real estate in an IRA. Working with Horizon Trust or a licensed professional specializing in self-directed IRAs and UBIT will go a long way toward helping you remain in compliance.

Can I use my IRA to invest in real estate with partners?

Yes, using your IRA to invest in real estate with partners is possible. Each partner can use their IRAs to purchase real estate and establish ownership shares, where all income and expenses are distributed proportionally.

For example, if one partner has a 60% ownership percentage and two other partners have a 20% ownership percentage, then income, expenses, and profits will be distributed accordingly.

Be sure to consult fully with Horizon Trust or a trusted IRA professional to ensure that you are well-versed in all rules and requirements related to co-investment with partners.

What happens if I want to sell the real estate property in my IRA?

If you want to sell the real estate within your IRA, the first step is to find a real estate agent and list the property for sale.

From there, you must inform your IRA custodian or administrator of the sale, who may request additional supporting documentation before you find a buyer, open a sales contract, and initiate the closing process.

Once the property is sold, all purchase funds are directed to your IRA custodian. Your property’s title and deed will be held under your IRA or transferred to your IRA if it’s under your name.

Any expenses and fees, such as agent commissions and property taxes, are paid directly from your IRA, not your personal funds. Any proceeds from the sale could be used to reinvest in other IRA assets, including non-real estate-related assets like cryptocurrency, precious metals, or stocks and bonds.

Regarding reporting, all transactions must be reported to the IRS, with any sales proceeds enjoying tax-deferred growth until distributions are taken out (under a traditional IRA) or tax-free growth under a Roth IRA. Remember that any distributions taken under a traditional IRA will be taxed upon retirement.

Consult with an IRA custodian if you need clarification on all tax implications of selling your IRA real estate property, including any penalties and prohibited transactions. One wrong move can jeopardize your ability to enjoy tax advantage status.