Standard investment assets, like stocks and bonds, may present a common path for basic investors, but the associated returns don’t always lend themselves to strong, exponential growth.  Real estate, however, can provide that, all while creating a robust portfolio that can remain strong even through inflation and dystopian markets.

As more and more people look to alternative assets for retirement, it becomes clear that your standard IRA is holding you back. Here’s everything you need to know about establishing a self-directed IRA to invest in real estate, including some essential self-directed IRA real estate rules you need to be versed in.

Self-Directed IRAs and Real Estate: An Overview

Most standard IRAs limit your investment options to stocks and bonds traded over public exchanges. A self-directed IRA (SDIRA) is structured similarly to a standard IRA but is managed by a custodian, which allows you to invest in alternative assets, such as real estate.

Self-directed IRAs can be structured in one of two ways, including a:

  • Traditional IRA, which allows for pre-tax contributions and tax-free growth. Distributions are subject to income tax.
  • Roth IRA, which is funded with after-tax dollars but also provides tax-free growth while the funds are in the account. Qualified distributions are not taxed.

You’ll also need to choose a self-directed custodian. Also known as a trustee, a self-directed custodian is tasked with holding assets and overseeing administration activities. For context, standard IRAs are often managed through banks or brokerages, but these financial institutes seldom allow for self-directed IRAs. Instead, you’ll need to work with a custodian specializing in this type of alternative asset investment account.

Learn more about the differences between custodians vs. depositories.

When you invest in tax liens, earnings come from the interest applied to the lien

Advantages of Using Your SDIRA to Purchase Real Estate

Increased investment control

When you open an SDIRA, you can invest in several types of real estate, including single-family properties, multi-family properties, commercial properties, and vacant land. Your custodian is merely passive, allowing you to invest in whatever asset you want as long as it is allowable by the IRS.

However, if you want to bypass your custodian entirely, you can open an SDIRA with checkbook control. This control lets you execute transactions and payments without waiting on your custodian. To accomplish this, you’ll need to open a checkbook LLC inside of your IRA.

Asset protections

Real estate purchase via an SDIRA is protected from bankruptcy. As such, you can make long-term investment decisions that will fund your retirement without worrying about how a financial setback may put you or your family in a financially challenging situation in the present.

High returns

Real estate investments can yield high returns, and those returns can either be used to directly fund your retirement or as a downpayment for additional investment opportunities. Plus, all earnings in a Roth account are tax-free, meaning you have additional opportunities to generate income via compound interest investments.

Passive income

If purchasing a residential or commercial property to rent or lease, you can establish an ongoing stream of rental income that will go directly back into your IRA account and grow tax-free until retirement.

Quicker growth potential

The IRS sets annual contribution limits for all IRAs, and if you exceed that contribution limit, you’ll be penalized. However, income earned from a property is not considered a contribution, and thus, you can continuously grow your IRA account despite contribution limits.

IRS Rules, Restrictions, and Prohibited Transactions

One thing to keep in mind when investing in self-directed IRA real estate is that the IRS places additional restrictions on these investments because they are so lucrative.

Here are a few self-directed IRA real estate rules to keep in mind as you invest.

1. Contribution limits

The IRS sets maximum IRA contribution limits that apply to both standard and self-directed IRAs. In 2024, IRA contribution limits will increase to $7,000. Individuals who are 50 or older can make an additional “catch-up” contribution of $1,000, increasing their total annual limit to $8,000.

The IRS also sets specific contribution and income limits for Roth IRAs, which factor in the account holder’s tax status and income.

2. Property ownership

When you invest in real estate using your SDIRA, you cannot be named as the property owner. Instead, the property title must be held in the name of the IRA.

3. Earnings and expenses

All expenses and earnings must come directly from and back to the IRA.  For instance, if you’re renting out a property held by your IRA, all rental income must go directly back into the IRA. You cannot collect that rent and use it for your personal financial obligations.

Similarly, if you’re paying property-related expenses, such as a property manager or contractors, the expense must be paid from the IRA. You cannot foot the bill yourself.

4. Prohibited use

You cannot use property held by your IRA for personal use. That means you or a disqualified person (e.g., spouse, ancestor, decedent, account fiduciary, etc.) cannot live in, set up an office in, vacation in, or otherwise benefit by occupying the property.

5. Prohibited transactions

IRS rules prevent you from engaging in a list of prohibited transactions. For real estate, prohibited transactions including:

  • Buying or selling your own property to your IRA or a disqualified person (or vice versa).
  • Using the IRA-held property as collateral.
  • Hiring a disqualified person to complete a task or service on the property, such as hiring a spouse to complete a remodeling project or renting out office space to a son.

6. Unrelated business income

Earnings from real estate held by an IRA are generally not subject to taxes outside those applied by the account structure you choose—Roth or Traditional.  However, if you use a non-recourse loan to purchase the property, you’ll likely be required to pay unrelated business income tax (UBIT) on the net profits from a financed property.

How to Invest in Real Estate with an IRA: Step-by-Step

Ready to purchase your first property? Here are 4 steps to help you get started.

1. Choose an SDIRA custodian. Though SDIRAs give you immense freedom, you’ll still need a custodian to start the process. And, because real estate investment via an IRA does come with a series of rules and regulations, it’s best to choose a custodian who is experienced in the real estate sector.

2. Fund your SDIRA.

You can fund and subsequently make a real estate purchase using the following methods:

  • Use a rollover to move funds from a qualified retirement plan, such as a 401(k), to your new SDIRA.
  • Use a transfer to move funds from one IRA (of a similar structure) to your new SDIRA.
  • Make a contribution that aligns with the most current IRA contribution limits.

3. Identify and research a property to purchase. Once you have a custodian pinned down, you can begin looking for investment properties, which can include commercial and residential properties as well as vacant land.

Always be sure to thoroughly research the property and ensure that it meets your investment goals and timeline.  SDIRA custodians will not complete this task for you, as you are responsible for due diligence. If you’re not well-versed in property investment, it’s best to speak with an expert who can help guide you.

4. Make your purchase. Depending on your IRA balance and the cost of the property, you can use the following methods to purchase a property:

  • Cash purchase, relying only on the funds in your IRA.
  • Partner with another SDIRA holder to purchase to combine funds to complete the purchase.
  • Apply for a non-recourse loan if you don’t have enough funds to make a purchase on your own and partnering is not an option. Note that non-recourse loans can be difficult to get and will likely result in UBIT.

FAQs: Self-Directed IRA Real Estate Rules

Can I use my self-directed IRA to invest in properties I already own?

No, you cannot use your SDIRA to purchase property from yourself or an individual or entity that is considered a disqualified person. Doing so is considered a prohibited transaction and will result in a penalty.

What are the rules for using IRA funds for property improvements?

If you need to make improvements to a property held by your IRA, you must do so using funds from the IRA. As such, payment for contractors, supplies, etc., must be taken directly from the IRA account.  You cannot pay for those items out of pocket.

Keep in mind that you also must be careful when considering who will complete the property improvements. You cannot complete them yourself, nor can you hire a disqualified person to do so.

How is rental income taxed within a self-directed IRA?

No, rental income, which is considered passive income, is not typically taxed in a self-directed IRA.

Can I live in or use a property owned by my self-directed IRA?

No, you cannot live in or use a property owned by your SDIRA.  For instance, if you used your IRA to purchase a vacation home, you or any disqualified person are prohibited from using the property.  The same is true for other use scenarios, such as renting office space or using it as a temporary dwelling.