Real estate investment by individuals is on the rise, but for the most part has been limited to real estate investment trusts (REITs) and real estate mutual funds. The rise of self-directed IRAs, which not only allow but encourage real estate products, is beginning to change the situation. Direct real estate investing is increasingly becoming an option for retirement-oriented investors looking to capitalize on real estate’s return potential and its capabilities as portfolio diversification and inflation hedge.
Self-directed IRAs offer investors the same discretion they usually have over their taxable investments, but allow for the deferred earnings growth. In the form of a self-directed IRA, investors can invest directly in real estate, mortgages, private placements and other non-traditional assets: Section 408 of the Internal Revenue Code allows the purchase of real estate with funds raised in many common forms of IRAs. , which includes a traditional IRA, a Roth IRA, and a simplified employee pension (SEP) IRA. Such structures allow investors to achieve significant flexibility in investment options, greater control over their retirement assets and the investment potential offered by direct real estate investments.
Key learning points
- Self-directed IRAs provide deferred earnings growth.
- Self-directed IRAs are also managed by the account owner rather than a financial institution.
- Investment options for self-directed IRAs are not limited to traditional assets.
A self-directed IRA is one that allows the account owner to actively manage the portfolio, make investment decisions, and choose products — everything from stocks and bonds to alternative investments — rather than having a financial institution do it.
To invest using a self-directed IRA, the IRA must be held with a qualified trustee or custodian. Generally, these trustees provide administrative services, such as tracking contributions and other activities, filing required IRS reports, issuing client statements, and providing information regarding the rules and regulations applicable to IRAs (for example, the contribution limits and deductibility rules, the rules for benefits and the penalties for early withdrawals).
Investment Options for Self-Directed IRAs
The investment options for self-directed IRAs are usually not limited to traditional assets, but include everything allowed by the IRS. This creates higher diversification potential than regular IRAs, where investments are often limited to mutual funds or certificates of deposit (CDs). While all types of investments are allowed under federal regulations, not all custodians offer all asset classes, including real estate or mortgages. Therefore, potential account holders should check with the custodian before setting up the IRA.
These IRAs cannot invest in IRS-prohibited assets, such as life insurance and collectibles, and must follow the same IRS rules and regulations for regular IRAs.
While the IRA is a non-discretionary account, regulations make the IRA owner responsible for complying with all legal requirements. Since the custodian does not usually determine whether the investment complies with legal requirements or provides legal/tax advice, investors interested in self-directed IRAs should seek advice from an independent tax or legal advisor.
The investment options available for self-directed IRAs go beyond stocks and bonds and can include the following types of real estate vehicles:
It is important to find a custodian who is experienced in handling these investments, as special tax filing rules and operating procedures apply.
You can buy land or real estate (residential and commercial) in your IRA, as long as it doesn’t result in self-dealing. This means that you cannot buy a house or building in which you will live or do business. Your IRA also cannot buy property from you or a company in which you or certain members of your family have a certain percentage of ownership. The IRA is also prohibited from selling any property to you or any of the above parties.
Operating procedures and taxes
Once you have provided the documentation and proper instructions for purchasing the property, your IRA custodian will initiate the purchase for your IRA. The title of the property reflects the name of your IRA custodian. All property management and property-specific expenses must be made through the IRA, so the IRA must have enough cash to pay these amounts. Relying on outside capital to fund management costs can result in the loss of tax benefits or incurring penalties.
If the property is financed with debt, it can create what’s called unrelated business taxable income (UBTI), which is taxable under the IRS code. This is unlike other income, which is deferred until withdrawn from the IRA. Investors wishing to invest in debt-funded assets should contact their tax advisor to explore the tax implications.
For investors who want more leverage over their investments, checkbook checking is another option. This allows the IRA owner to make purchases by writing checks on behalf of the IRA. The transactions are facilitated through an LLC owned by the IRA. Other legal structures, such as S corporations, are usually unavailable because IRAs are not investors. Creating an LLC to make IRA investments can give an investor even more control over their assets and reduce certain custody fees.
Typically, the IRA owner has the ability to perform certain management functions, such as advertising, collecting and depositing rent checks, and paying related bills. This gives the investor a big advantage, especially when buying foreclosures, which is usually a time-sensitive proposition that requires the ability to write checks at the courthouses.
Direct investing in real estate has historically provided significant wealth for investors who understand the risk-return tradeoff of this asset class. Using self-directed IRAs gives investors the ability to invest directly in real estate and other real estate-related assets, while providing the tax-deferral capabilities of traditional IRAs.
It comes down to
In the form of a self-directed IRA, investors can invest directly in real estate, mortgages, private placements and other non-traditional assets.️️️️️️️️️️️️️️️️️️In some cases, IRA owners get checkbook access to their IRA balances. Such structures allow investors to achieve significant flexibility in investment options, greater control over their retirement assets and the investment potential offered by direct real estate investments.