Boost Your Retirement: Unlock Real Estate Investment Potential with a Self-Directed IRA

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rewrite this article with david rey as author Using Your IRA to Buy Real Estate

Property is a rewarding but risky proposition for retirement accounts

By TIM PARKER Updated November 30, 2023

Reviewed by ANDY SMITH

Fact checked by YARILET PEREZ

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When it comes to individual retirement accounts (IRAs), financial assets—stocks, bonds, mutual funds, or exchange-traded funds (ETFs)—are the usual investment suspects. Still, it’s possible to hold real estate in your IRA under certain conditions. For example, you can buy single-family or multiplex homes; apartment buildings; commercial properties such as retail stores, hotels, office complexes, raw land and lots; and even boat slips.

However, it’s not as easy as purchasing a few hundred shares of stock. If you want to plunge into property purchases through your self-directed IRA, you need to know the rules—and there are many of them.

KEY TAKEAWAYS

You can hold real estate in your IRA, but you'll need a self-directed IRA.

Any real estate property you buy must be strictly for investment purposes; you and your family can't use it.

Purchasing real estate within an IRA usually requires paying in cash, and the IRA must pay all ownership expenses.

Holding real estate in your IRA can be tricky, with tax issues and red tape. But on the other hand, property can provide you with a good (or great) rate of return and diversify your portfolio.

The Right IRA for Buying Investment Property

First of all, your IRA has to be self-directed. The term “self-directed” means that alternative investments are accepted or offered by the IRA custodian, the financial institution, or the company responsible for record-keeping and Internal Revenue Service (IRS) reporting requirements. A self-directed IRA is independent of any brokerage, bank, or investment company that would make decisions for you (most brokerage accounts don’t allow real estate holdings, anyway).

To buy and own property via your IRA, you will still need a custodian, an entity specializing in self-directed accounts that will manage the transaction, associated paperwork, and financial reporting. Everything goes through the custodian to keep you from violating the strict rules regarding these real estate transactions.

As you would expect, the custodian will charge a fee for the service. However, it won’t advise you on how to best structure your holdings. Instead, this custodian’s job is to handle the back-office work.

Before we look at the rest of the rules, understand this basic fact: You and your IRA are two separate entities. Your IRA owns the property—you don’t. Therefore, the title to the property will read “XYZ Trust Company Custodian [for benefit of] (FBO) [Your Name] IRA.”

If you buy real estate with your IRA improperly, you can disqualify the IRA. If that happens, all the funds in it immediately become taxable.

What Is and Isn’t Yours

Your real estate property must be purely an investment. You can’t use it as a vacation home, a place for your kids to live, a second home, or an office for your business. These rules apply to you and to people the IRS deems “disqualified.” So who is considered a disqualified person?

Making the Purchase in an IRA

Your IRA balance will have to be pretty high because getting a mortgage to purchase property inside an IRA isn’t easy. You’ll likely have to pay in cash, which takes a big bite out of the account and affects your rate of return down the road.

Real estate investors often put down a small amount and take advantage of still relatively low-interest rates to leverage the purchase, figuring they can make more money on the property than they’ll pay in interest. If you can’t finance your real estate purchase, you lose that potential for a significant return on investment (ROI).

Some banks will consider loans for this sort of transaction, but it presents another problem: Any revenue from the property may then be considered unrelated business taxable income (UBTI). You can learn more about UBTI from Section 511 of the IRS Internal Revenue Code (IRC).

Owning the Property in an IRA

As your IRA doesn’t pay taxes, you can’t take advantage of the deductions that come with owning real estate. Because you’ve paid cash, there are no mortgage interest payments to deduct. Nor do you get the benefits of property tax deductions or depreciation. If your property generates rental income, every bit of it goes right back into your IRA. As you don’t own the property, you can’t pocket any of the income. (Of course, you will get the money eventually when you make withdrawals from the account at retirement.)

On the bright side, none of the maintenance or other associated costs of owning real estate comes out of your pocket. The IRA pays for everything. However, this is not without drawbacks. Every dollar that comes out of your IRA is a dollar that no longer gets a couple of decades to appreciate in value tax-free.

One colossal risk is maintenance expenses that can drain your IRA's cash and lead to expensive penalties if you "overcontribute" to the account to cover them.

And what happens if a property incurs a series of major expenses that push your IRA balance so low that the account doesn’t have enough money to pay for it? Remember, you can’t pay for anything relating to this property out of your pocket, and IRA contributions are limited: The annual contribution limit for 2023 is $6,500 and $7,500 if you're 50 or older ($6,000 and $7,000 in 2022).

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If that doesn’t cover the repair, and you have to deposit more, you’re on the hook for penalties associated with contributing too much. This is a significant risk, as property can often require pricey upkeep, and the income you get from rentals may not cover what you need to spend in a high-maintenance year.

Selling the Property in an IRA

Work out a sales price to sell your property just as you would with any other real estate holding. Once both parties agree on a price and terms, request that your custodian sell the property on behalf of your IRA. All money will go back into your IRA, either tax-deferred or tax-free, depending on the makeup of your IRA.

One final consideration: liquidity. Just how easy is it for you to get out of the investment? With stocks, it’s relatively easy. Sometimes you can have your money back in seconds. In contrast, real estate is a notoriously illiquid investment. It may take a long time to divest, and you could lose money along the way. As nearly ten million people learned in the Great Recession of 2008, you could find yourself with an asset worth less than the amount of money you owe on it.

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Pros and Cons of Property in an IRA

We've mentioned so many hassles and drawbacks that you might be wondering at this point if there is any point in putting property in an IRA. Historically, real estate has been an excellent long-term investment as property values rise over time, and long-term appreciation goes hand-in-hand with the long-term investment horizon of a retirement account. In the short term, any income the property generates is tax-sheltered within the IRA. Finally, as a hard asset, real estate helps diversify a portfolio otherwise invested in equities and other securities—not the worst idea in the world.

Pros

Real estate helps diversify a portfolio, often moving counter to financial markets.

Real estate has historically appreciated over time, ideal for an IRA's long-term investment horizon.

Real estate can provide a steady income stream from rents, and any rental income you collect grows tax-free within the IRA.

You can buy, sell, flip, and accumulate properties.

Cons

You need to set up a self-directed IRA with a custodian.

You can’t claim deductions for property taxes, mortgage interest, depreciation, and other property-related expenses.

All expenses, repairs, and maintenance costs must be paid with IRA funds, and you must pay others to do them and manage the property.

You and your relatives can’t live in or run a business out of the property.

Can You Finance Real Estate With Self-Directed IRAs?

It's important to remember that funds (cash) from the IRA are generally used to purchase the property; additionally, the IRA will own the property and it can only be used for investment purposes.

Who Owns Property in a Self-Directed IRA?

Funds from the IRA are used to purchase the property, and the account legally owns the property.

Can I Build a House With A Self-Directed IRA?

An IRA can only be used to purchase investment property, so you cannot build a house using the account even if you intend to use it as an investment property.

The Bottom Line

Using a Roth or traditional IRA to buy an investment property is not for the faint of heart, nor is it for anyone unfamiliar with the differing types of individual retirement accounts. Real estate investing of any type is quite risky or, at best, high maintenance; for an IRA, real estate is a particularly high-risk choice. Not only may property values drop rather than rise, but a year of significant maintenance costs could also subject you to penalties if your income and IRA contribution limit doesn't cover repairs you can't afford to ignore.

Unless you have the time and expertise to manage real property, you are probably best off with more mainstream strategies for your IRA. Or consider securitized real estate options, like real estate investment trusts (REITs) or mutual funds and ETFs that invest in property. These are an indirect form of property ownership, but they're a more straightforward, liquid proposition—and they can also be held in regular IRAs.

Using Your IRA to Buy Real Estate: A Rewarding But Risky Proposition for Retirement Accounts

By David Rey