Self-directed IRA for Real Estate: Is it Worth it?
Most of you probably know what an Individual Retirement Account (IRA) is. It’s a retirement savings account that has special tax benefits, much like a 401k you may have at work. How about a self-directed IRA? This one may have you scratching your head a bit. Not to worry, this post will help you learn what a self-directed IRA is and if it’s right for you. Here’s a tip: it could help you buy more real estate.
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What is a Self-directed IRA Anyway?
A self-directed IRA is a retirement account you control. Unlike a Traditional IRA or your 401k at work, you can put your retirement funds in alternative investments such as oil and gas partnerships, precious metals, horses (yes, horses), sunflower farms, and you guessed it…real estate! Make sure the investment is legally approved of course.
Now that I have your attention, let’s dig into the idea of using a self-directed IRA to invest in real estate.
First of all, set me say that a self-directed IRA can be a good thing in itself. An IRA has certain tax benefits that you don’t get by throwing your money into a savings account. A self-directed IRA goes further by giving you options beyond throwing all of your eggs in one basket via mutual funds. Buying real estate with money that you rendered basically untouchable until 59 1/2–now that’s priceless, or so it seems. You could’ve had an old 401k that you rolled over into a traditional IRA. It could now be a substantial amount of available money that was previously off-limits to you.
How Does it Work?
Before we begin, if you are seriously considering a self-directed IRA, discuss this with your financial advisor, CPA, or tax attorney. Everyone’s situation is different.
There are two core methods people use to set up a self-directed IRA:
- Find an IRA custodian who will help you rollover your funds. You’ll find a plethora of custodians available, so choose carefully as this is important. Fees could vary from $100-$2500 with charges for each transaction. The custodian will handle all of the financial transactions in and out of the account since they will have control of the money.
- Performing step #1, but also setting up your own LLC. Once the LLC is formed, tell the IRA custodian to invest in the LLC instead, therefore “owning” the LLC. The manager of the LLC (that’s you!) controls the IRA funds and gives you “checkbook control” of the IRA. There are no fees for the transactions you make and you don’t need to wait on the custodian to make transactions for you.
Watch Out: Be very careful with the self-directed IRA “LLC”. Again, you should get in touch with a tax attorney and a business attorney before exploring this route seriously. Here’s one way to think of it…with a self-directed IRA you can buy the bakery, but you cannot be the baker. This is treading a fine line.
Self-directed IRA Advantages: Escaping Mundane Mutual Funds and Achieving True Diversification
There are some overall advantages to using a self-directed IRA to invest in real estate:
- You suddenly have access to capital to invest in real estate. You might not have the free cash to invest without it and the deal is too good to pass up.
- It moves you away from typical mutual funds and helps diversify your retirement holdings. Once you set the self-directed IRA up, you can invest in other assets such as land, single family homes, commercial property, apartment buildings, mobile homes, and tax lien certificates. Of course, these are all examples of real estate assets. The possibilities are endless.
- All income and gains generated by this pre-tax retirement account will flow back into the retirement account tax-free.
- You aren’t paying taxes on the contributions you make.
- If you use a Roth IRA as a self-directed IRA, you get the benefits above, but you won’t ever pay taxes on your contributions or gains, as long as you wait until retirement (i.e. age 59 1/2) to take the funds out.
Disadvantages: It’s Not All Rainbows and Lollipops
- A self-directed IRA is complicated and can be difficult to set up and manage. It’s not near as easy as a standard Roth IRA or Traditional IRA that your financial advisor sets up for you.
- Custodians charge a fee to set up the self-directed IRA, often $100-$2500. They also charge fees for each transaction. It’s important to analyze the custodian fees and determine how that affects your overall investment.
- You lose some control over the investment since the custodian controls all of the financial transactions on your property. There’s the Self Directed IRA LLC route but that is just way too risky to be practical.
- You can’t use your real estate asset for personal use at all. If your property is vacant, and you decide to sleep there one night, you just engaged in something called “self dealing” and used your tax-advantaged asset for personal use.
- You can’t convert the IRA real estate into personal real estate later since you would incur an early withdrawl penalty if you are under 59 1/2. You would have to sell the real estate, withdraw it, take the penalty on the money, and purchase the property personally. Of course that is ridiculous!
- Let’s say you bought a nice rental in the Florida keys under your self-directed IRA and wanted to send your mom down there for a week, even if you rented it out to her. Nope, sorry! The IRS prohibits you from renting the property to relatives.
- The real estate under the self-directed IRA cannot be used as collateral for another mortgage.
- Property taxes, mortgage, etc. has to be paid out of the IRA, requiring you to keep a cash balance in there. Considering you can only contribute $5,500 a year to the IRA, this could be challenging if you were just barely able to squeeze out a property.
- IRA losses can’t be written off: depreciation, expenses, etc. can’t be deducted from your taxable income because you never paid taxes on the IRA funds to begin with. What if your losses exceed your gains? In certain cases, a regular investment loss could offset other income…as long as it’s passive income. I’m not a tax expert and I don’t play one on the Internet, so check the IRS website to learn more about passive income.
- The self-directed IRA space is rife with scams. Make sure the custodian is registered with the state securities board.
Remember to Do Your Due Diligence
You’ll hear me say it a lot. Due diligence is the cornerstone of real estate investing. As with any investment, you want to have all of your bases covered. That’s especially true with a self-directed IRA. A tax attorney can help you evaluate investments to ensure you aren’t “self dealing” or risking a disqualified investment.
What do you think about self-directed IRAs? Leave us a comment below!
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Before you leave:
Disclaimer: The information presented does not consider your particular investment objectives or financial situation and does not make personalized recommendations. This information is not intended to be a substitute for specific individualized tax, legal, or investment planning advice. Where specific advice is necessary or appropriate, AssetRover recommends consultation with a qualified tax advisor, CPA, Financial Planner or Investment Manager.
Don't forget to check out our free rental property calculator. This will be a valuable tool in your arsenal as you analyze your existing or potential rental properties.
Thank you for your ongoing support and happy investing!
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