A self-directed IRA opens the door to alternative assets, many with higher earning potential than standard securities, like stocks and mutual funds. Self-directed real estate, in particular, is a popular asset, especially for investors who wish to purchase and rent a property to secure a consistent income stream. Here’s everything you need to know about purchasing and managing a self-directed IRA rental property.

Benefits of Managing a Rental Property with a Self-Directed IRA

Managing a property with a self-directed IRA (SDIRA) can help you achieve your retirement goals faster by adding an ongoing stream of passive income to your IRA portfolio.

Depending on the type of account you open, all rental income can be collected tax-free inside your IRA.

Further, the self-directed IRA rental property serves as equity; if you choose to sell it, earnings go directly to the IRA, increasing the value of your portfolio and leaving you with more capital to invest in other assets, including new real estate opportunities.

How to Invest In Rental Properties with an IRA

If you’re considering using your IRA to invest in rental properties, these tips can help you get started.

1. Open a Self-Directed IRA

Standard IRAs are great options if you want a managed retirement account, but your investment options are limited to common assets, such as stocks, mutual funds, and bonds.  If you want to invest in real estate, for rental purposes or otherwise, you’ll need to open and fund an SDIRA.

SDIRAs are special accounts that allow you to hold alternative securities, including real estate, precious metals, promissory or mortgage notes, and liens.

The process to open an SDIRA is similar to opening a standard IRA, but you’ll need to work with an IRS-approved custodian, trust, or other entity. This contrasts with a standard IRA, which can typically be opened at a bank or brokerage firm.

2. (Optional) Open an LLC

When you open a standard SDIRA, you’ll be required to work directly with your custodian to carry out transactions, such as issuing payment for the property you wish to purchase. Though quality custodians aim to see transactions through as efficiently and quickly as possible, this can add to the total processing time.

On the contrary, if you open an LLC in the name of your SDIRA, you are designated as the managing member and gain what is known as checkbook control. Checkbook control allows you to access SDIRA funds directly, such as writing a check for a rental property purchase.

An SDIRA LLC with checkbook control also provides unique benefits after purchasing a rental property. For instance, you pay for related expenses, such as property management or hired repairs, directly from the SDIRA account and send rent or lease payments back to the account.

Pro tip: Make sure all income from your rental property goes directly back to your SDIRA account. Keeping income in a personal checking or savings account, or even another retirement account, violates IRS rules, which state all earnings from an SDIRA-held asset must be held in the SDIRA account.

3. Purchase Your Rental Property

Once your SDIRA is funded, there are several options to purchase a rental property, including:

Direct Purchase

If you have enough funds in your SDIRA, you can make a direct purchase by working with your custodian or leveraging LLC checkbook control.

Partnership

Another way to purchase a self-directed IRA rental property is by partnering with another SDIRA holder. This can help you increase your buying power, especially if you don’t have enough funds in your SDIRA. Earnings are split based on how much you invest.

Syndication

If you want to invest in a larger property, such as a commercial building or condo, consider investing by syndication. In this scenario, multiple investors join together, with one individual or entity acting as the investment sponsor and is tasked with choosing the investment property, getting financing, and managing the property. You will become a passive investor. 

Non-Recourse Loans

A non-recourse loan is an option if you don’t have enough funds in your SDIRA and either can’t or would prefer not to partner with another SDIRA holder. Non-recourse loans are secured by the property for which they are used and issued to the SDIRA. So, if you use a non-recourse loan to purchase a rental property and fail to meet your repayment obligations, the loan holder can seize the property but not your personal assets.

SDIRA non-recourse loans can be risky for lenders and often have higher interest rates, shorter repayment terms, and more stringent eligibility criteria than a traditional mortgage. It’s also important to note that earnings from the rental property are subject to unrelated business income tax (UBIT) on the portion of the financed rental property.

4. Manage Your Rental Property

Management is another important aspect of investing in rental properties.

There are generally three ways you can choose to manage your rental property:

• Manage directly. Rental income goes through the custodian and into the IRA, and all expenses are paid via the custodian at your request.
• Collect funds via your LLC.  Expenses and earnings pass through the LLC checking account, with you acting as the LLC manager. This is often the easiest option for real estate investments held in an IRA.
• Hire a property manager. The property manager collects rent, pays bills, and manages the property. All cash flow is through the IRA.

5. Sell Your IRA Property

In many ways, selling your IRA property is similar to selling a non-IRA property, but there are some key steps you can take to make the process easier and reduce the risk of any issues along the way:

•  Work with a real estate agent well-versed in IRA property transactions. A real estate agent who has experience with IRA transactions can ensure everything, including paperwork, meets the legal requirements.
• Make sure your IRA is recorded as the seller (not you) on all relevant paperwork, including listing agreements and inspections.
• Be aware of disqualified persons and prohibited transactions. You can’t, for instance, sell the property to a child or parent. If the property needs work before the sale, you can’t hire a business, like a contractor, owned by a disqualified person. Likewise, you can’t complete the work yourself, as you are considered a disqualified person.
• Work with your custodian to complete the sale and take note of any documentation required. This can include:
  • Sell direction letter
  • Purchase contract
  • Grant deed or warranty
  • Escrow instruction (if applicable)
  • Escrow or title opening package (if applicable)

Contacting your custodian before you start the sales process can ensure you’re well-prepared with the required documentation and setup for an efficient and expedient process.

• Be prepared for any unrelated business income tax (UBIT) if applicable. If you financed your self-directed IRA rental property, you may be required to pay UBIT on the proportion of the property that is financed.

Investing in rental properties can be a lucrative investment. By arming yourself with the right tools and knowledge you can increase your gains exponentially and avoid potential obstacles.

FAQs

Can I use funds from my existing IRA or 401(k) to invest in rental properties?

If you have a standard IRA or 401(k), you cannot use funds from the accounts to purchase rental properties, as those accounts cannot hold alternative assets like real estate. However, you can rollover or transfer funds from an IRA or 401(k) to a self-directed account and then use that account to invest in real estate.

Are there any restrictions on the types of properties I can invest in with an SDIRA?

You cannot use SDIRA funds to purchase a property that you plan to use as a primary residence, vacation home, office space, etc. SDIRA-purchased real estate cannot be used to directly benefit the account holder or other disqualified person, such as a decendant or ascendent. For instance, you nor a disqualified person, can set up office space in a commercial real estate property you purchased with SDIRA funds. Similarly, you cannot rent the property out to your child or parent.

How do I find a reputable SDIRA custodian or trustee?

You can begin your search for a reputable SDIRA custodian or trustee by checking the non-bank trustees approved by the IRS. This list ensures that you’ll be working with a custodian that meets the requirements of the U.S. government.

After identifying approved custodians, the following steps can help you find a match:

• Speak with experienced friends, family, colleagues, and financial professionals who can recommend a trustworthy SDIRA custodian.
• Reach out to prospective custodians directly to determine if they specialize in your chosen asset(s), such as real estate, and to get a feel for how they engage with clients.
• Review and compare custodian fees, favoring those who are transparent and up-front about costs.

Ready to begin working with a custodian: 7 Tips for Finding the Right SDIRA Custodian.