Real Estate in Your Self-Directed IRA

If you’re running a self-directed retirement account, you can think about adding real estate investing to your portfolio. Alternative investments, like real estate, are a great way to diversify— and they come with some specific advantages over equities or other kinds of asset-based investment.

Investors do this all the time. They utilize the tax-deferred advantages of their IRA to buy properties or otherwise get involved in real estate. Whether you have spent years putting away for a rainy day or have diligently been adding to your savings account, sometimes you have to take an extra step to make the most of your individual retirement plan. The most savvy savers are considering how to get some of the unique financial rewards of investing in real estate assets through the vehicle of their self-directed retirement accounts.

Learn how Privy’s unique platform can help you confidently invest your retirement savings in real estate.

What is a Self-Directed IRA?

A self-directed IRA (SDIRA) is an individual retirement account (IRA) that allows investors to hold a broader range of IRA investments than traditional IRAs, which typically limit investments to stocks, bonds, and mutual funds. With a self-directed IRA, you have the freedom to invest in alternative assets, such as real estate, precious metals, cryptocurrency, private equity, and more.

The key difference between a traditional IRA and a self-directed IRA is the level of control you have over your investment choices. In a self-directed IRA, you act as the decision-maker, selecting and managing your investments, whereas a traditional IRA is typically managed by a financial institution or brokerage that makes the investment decisions on your behalf. This allows you to explore opportunities outside the stock market, such as real estate, which can provide diversification and potentially higher returns.

What Types of Real Estate Can I Include in a Self-Directed IRA?

As a real estate investor, there are several investment options within a real estate IRA. Self-directed IRAs allow for the purchase of residential properties, commercial properties, or industrial real estate, and they even allow for the purchase of raw land.

Some real estate investors like to buy up undeveloped property and subdivide it into buildable lots. They work with municipalities to create new lot lines that allow them to build on these parcels. Others like to specialize—instead of buying widely different types of properties, they will focus on a specific asset class: single-family homes, multi-family, vacation rental properties, condominiums or townhouses, or single-year lease commercial properties—you get the picture. The idea is that specialization in a type of investment helps build expertise in a niche area of the market.

Some investors like to have a smaller piece in a larger investment, and rather than buying real estate outright, they are involved in a group investment. A real estate syndication is a group investment in a larger real estate project, such as an apartment complex or commercial development. Traditional IRAs can invest in publicly traded Real Estate Investment Trusts (REITs), a self-directed IRA allows you to invest in non-traded REITs or private REITs, which may offer higher returns but come with higher distributions.

Self-directed IRAs allow for a wide spectrum of real estate investments. Think about how your IRA can help fund your portfolio in a local market.

Rules and Regulations for Investing in Real Estate with a Self-Directed IRA

1. Prohibited Transactions

The IRS prohibits certain transactions within a self-directed IRA, including self-dealing and transactions involving disqualified persons. Disqualified persons include yourself, your spouse, your descendants, ascendants, family members, and certain entities in which you have a significant interest. For example, you cannot use your IRA to purchase a property that you or a disqualified person currently own, nor can you live in or use a property owned by your IRA.

2. No Personal Use of the Property

If you hold real estate in your self-directed IRA, neither you nor any disqualified person can live in or use the property for personal purposes. The property must be held strictly as an investment.

3. All Expenses Must Be Paid by the IRA

Any expenses related to the property, such as maintenance, repairs, property taxes, and insurance, must be paid using funds from the IRA. You cannot pay these expenses out of pocket, as doing so would be considered a prohibited transaction. When in doubt about the use of funds, always consult with a financial advisor you trust.

4. All Income Must Go Back into the IRA

All income generated by the property, such as rental income, must be deposited back into the IRA. The income cannot be withdrawn for personal use until you are eligible to take distributions from your IRA.

5. Understanding Unrelated Business Income Tax (UBIT)

Another important consideration when investing in real estate through a self-directed IRA is the potential for Unrelated Business Income Tax (UBIT). UBIT can apply if your IRA earns income from activities that are considered unrelated to its primary purpose, such as leveraging investments with borrowed funds, operating a small business, or engaging in active business operations through an IRA LLC. For instance, if your IRA purchases real estate using a loan, the income generated from the portion of the investment that is debt-financed may be subject to UBIT.

If your IRA owns and operates a small business directly or through an IRA LLC, the income from that business could also trigger UBIT. It’s crucial to understand how UBIT could impact your returns, as it may reduce the overall profitability of certain investments. Consulting with a tax advisor before engaging in activities that might trigger UBIT is advisable to ensure compliance and optimize your investment strategy.

6. No Borrowing or Loan Guarantees

If you use leverage to purchase real estate in your self-directed IRA, the loan must be a non-recourse loan, meaning the lender cannot go after your personal assets if the loan defaults. Additionally, you cannot personally guarantee the loan.

6. Required Minimum Distributions (RMDs)

If you have a traditional self-directed IRA, you are required to start taking minimum distributions at age 73. This can be challenging if your IRA holds illiquid assets like real estate. To meet RMD requirements, you may need to sell the property, take an in-kind distribution, or ensure you have sufficient liquid assets in the IRA to cover the distribution.

Types of Real Estate Not Allowed in Self-Directed IRAs

Real estate investors can participate in all sorts of real estate purchases with a self-directed IRA. However, there are some key ground rules.

One of the most extensive guidelines in real estate investing with a self-directed IRA is avoiding what experts call ‘self-dealing.’

The bottom line is that in real estate investing with a self-directed IRA, it’s important to avoid having a personal stake in the property.

IRA investors can’t help fund their own purchases with IRA money. They can’t use the IRA to make supplemental purchases. They can’t even personally work on the properties that they have bought with the IRA, as this is also considered self-dealing. If you’re the type who wants to have sweat equity in an IRA real estate deal, funding with the self-directed IRA might not be for you.

These prohibitions on real estate investing are intended to prevent investors from abusing the IRS tax benefits of the retirement plan. However, some see them as excessively draconian restrictions and choose to invest in real estate differently.

There’s also the criticism that many of these self-directed IRA rules regarding real estate are very nebulous. For example, there are rules about having family members move into a property. That might be subject to interpretation based on the time frame, etc. Some of these rules on sweat equity can be fairly vague.

It gets tricky, partly because property investment is such an inherently personal endeavor. Many of us have been acculturated to a model of “self-work” – we want to work on the properties ourselves rather than paying contractors to do everything. The rules are hard to enforce, but the IRS might get you on a technicality in various ways. So in these cases, it’s better to avoid using the IRA because if it’s compromised, all of the IRA funds can be taxable.

What Can I Do with Real Estate in my IRA?

As long as you stay away from self-dealing in all of its forms, investors can do a lot with real estate in a self-directed IRA. Running the funds through a custodian allows for capital gains from real estate appreciation. It also allows for some proceeds from various property management or improvement forms. Investors can add value to a property using trusted skilled contractors, again, as long as there’s not the threat of self-dealing— for instance, if this trusted contractor is a family member, that may not be allowed.

As in other kinds of real estate investing, there’s a lot that portfolio holders can do with IRA funds. Use the IRA to get involved in a relatively illiquid market where long-term holding often provides good gains.

Steps to Invest in Real Estate with a Self-Directed IRA

Investing in real estate through a self-directed IRA requires careful planning and execution. Here are the steps you need to follow:

1. Open a Self-Directed IRA

The first step is to open a self-directed IRA with a custodian who specializes in these types of accounts. Not all custodians offer self-directed IRAs, so choosing one that allows for real estate investments and understanding the rules and regulations is important.

2. Fund Your IRA

Once your self-directed IRA is established, you need to fund it. You can do this through a rollover from an existing IRA or 401(k), a transfer from another IRA, or by making new contributions (subject to annual contribution limits).

If you choose a Roth IRA, your contributions will grow tax-free, and qualified distributions are also tax-free. If you choose a traditional IRA, your contributions are tax-deferred, meaning you won’t pay taxes until you take a retirement withdrawal. When those withdrawals occur, they will be subject to income tax.

3. Identify Investment Properties

With funds in your IRA, you can start looking for investment properties. It’s important to perform due diligence on any property you’re considering, including analyzing the potential return on investment, assessing the property’s condition, and understanding the local real estate market.

4. Make an Offer and Purchase the Property

Once you’ve identified a property, you must make an offer through your IRA. The title of the property must be in the name of the IRA, not in your personal name. The custodian will handle the transaction on behalf of the IRA, and all related expenses must be paid from the IRA.

5. Manage the Property

After the property is purchased, it needs to be managed according to IRS rules. You can hire a property manager to handle day-to-day operations, or you can manage it yourself, but you cannot perform any physical work on the property. All income and expenses must flow through the IRA.

6. Monitor and Adjust Your Investment Strategy

Real estate is a long-term investment, and it’s important to regularly monitor the performance of your properties. Keep an eye on rental income, property values, and expenses, and be prepared to adjust your investment strategy if needed.