Using a self-directed IRA to invest in real estate

Self directed IRA
Self directed IRA

In the commercial real estate market, investors are constantly looking for creative funding ideas to earn maximum returns. The ability to utilize retirement funds for diversifying their investments in commercial real estate has made it easier for financiers and builders to acquire a commercial property with the fees and costs being directly paid from their self-directed IRAs. In this blog we will discuss how to use self-directed IRS to invest in real estate in this blog we will discuss the strategies of using self-directed IRAs to invest in commercial real estate and the pros and cons of real estate investing with IRA.

What is a Self-directed IRA?

An IRA is an individual retirement account that is a retirement plan that enables an individual to earn tax-deferred/tax-free profits.

Similarly, a Self-directed real estate IRA is a government-sponsored retirement plan that allows real property investments to grow tax-deferred/tax-free over time and generate maximum growth.

Investor interested in adding real estate investments to their portfolio can use their self-directed IRA. While traditional IRAs allow investments in stocks, bonds, and mutual funds, self-directed IRA custodians permit a wide range of investments. These include precious metals, private equities, and real estate.

In a self-directed IRA, the investor places their money with the custodian who is responsible for executing the investments on the behalf of the investor.

A custodian is a financial entity that Insurers that all IRS and government regulations are complied with in the investments.

However, said custodian cannot act as a financial advisor to the investor. Moreover, they cannot source or suggest specific investments to the account holder. 

Therefore, a self-directed IRA allows its account holder to invest in several asset classes not legally allowed by other IRS. These include:

  1. Tax lien certificates
  2. Limited partnerships
  3. Private placements for businesses
  4. Real estate crowdfunding deals
  5. Traditional real estate investments
  6. Cannabis REITs
  7. Cryptocurrency

Read more about Cannabis REITs in Lilypads’ blog here.

Which real estate asset classes qualify for self-directed IRA investments?

Within real estate, investors have the flexibility of using their self-directed IRA to invest in several property types including:

  1. Commercial properties
  2. Vacation rentals and other rental properties
  3. Fix and flips
  4. Multifamily buildings
  5. Co-ops

Purchasing Real estate with self-directed IRA

To purchase real estate with a self-directed IRA the beneficiary needs to set up an account first.

Several institutions allow investors to set up a self-directed IRA on their own. However limited investment options and complex IRS tax codes compel an investor to consult with their custodian. Therefore these custodians provide the account holder with lawful investments.

Hence an investor‘s ability to self-direct their retirement funds ultimately depends on whether they can transfer or rollover their capital to a custodian that allows them to self-direct their IRA.

An investor who has a 401(k) with their current employer must leave their present employer in order to be able to roll over to our self-directed IRA. In addition to this, if an investor has been making contributions to a bank or brokerage IRA, they can transfer those funds to a self-directed IRA.

For purchasing alternative investments such as real estate, the custodian and not the beneficiary of the self-directed IRA must hold the investment. The purchase contract is made in the name of the IRA since the property is an IRA investment. At this point, the custodian reviews the private placement investment to check its legal compliance. 

Next, the custodian signs the private placement purchase direction and proceeds to execute the investment on the beneficiary’s behalf. In addition to this, the beneficiary account must receive any potential distribution or profit from the sale of the asset.

Self-directed IRA real estate investments and its rules:-

When an investor buys real estate with an IRA, they must consider the following rules:

  1. They must purchase the property purely for investment purposes. So, an investor cannot use the property as a vacation home, for residential purposes, or for office use. The IRS also deems the following entities to be disqualified from using the property on the aforementioned basis:

The IRS also prohibits investors to purchase property from any of the disqualified family members mentioned above. Furthermore, an investor cannot sell, exchange, or lease property they already own to their IRA.

  1. ​​The Self-directed IRA must bear all asset-related expenses (maintenance, taxes, improvements, utility bills, etc). Hence, an investor has to request funds from their IRA custodian. 

The investor themselves cannot pay for the expenses as it is considered a prohibited transaction. Hence, the investor must ensure that the investment asset generates adequate cash flow to cover all its expenditures.

  1. The IRA account owner can oversee the property’s management. However, they cannot perform work on the property.
  1. If an investor obtains a nonrecourse loan for their IRA real estate investment, they must pay unrelated business income tax. Hence the IRA must pay taxes on the profits from the debt-financed percentage. This is usually applicable to ground-up development, hospitality properties, buy and flip strategies, etc.

Decoding the tax benefits of real estate investments using self-directed IRA

Using a self-directed IRA to buy real estate provides several tax benefits.

Both a traditional and Roth IRA are the most popular IRA real estate investment options. In a Traditional IRA, no taxes or dividends are paid on dividends or capital gains on investment until distributions are withdrawn from the account during retirement.  As a result, returns on investment grow tax-deferred.

With a Roth IRA, an investor pays taxes on their income. So, the IRA real estate investment gains grow tax-free and the investor withdraws on a tax-free basis.

Real estate IRA investment strategies

If a real estate investor lacks the full purchase amount in their IRA, they can obtain a non-recourse loan to buy an investment property.

Further, the investor can open a self-directed IRA LLC( Checkbook IRA). It is considered as one asset with IRAR. Therefore, they are charged for a single asset, regardless of how many assets there are within the LLC itself. The LLC holds multiple investments while the IRAR holds an investor’s LLC as one IRA investment.

A real estate investor can also enter into an agreement with other investors to purchase an asset. As a result, each of them can own a portion of the property proportionate to the funds they contribute. Therefore, the IRA would receive the same proportion of any profits.

Investment strategies can also include proper due diligence on the various types of retirement plans. So, an investor can combine and diversify their strategies for maximizing their investment returns. For instance, they can invest through an IRA LLC while partnering with another self-directed account.

Roth IRA real estate investments and its rules

Roth IRA is funded with pre-tax dollars in which distributions are taxed as ordinary income. Investing in real estate with Roth IRA deducts a portion of the tax paid at distribution. Therefore,  the distributions are tax-free.

Additionally, an account owner can hold about any investments in this popular retirement account. These include stocks, bonds, mutual funds, money market funds, exchange-traded funds (ETFs), and annuities.

Some real estate investors believe that paying taxes upfront provides an advantage over overpaying tax on distributions as in traditional IRAs.

Pros and Cons of real estate investing using a Self-directed IRA

Investing in any kind of real estate is risky or, at best, high maintenance. Let’s discuss the pros and cons of investing buying real estate with an IRA:-

The potential benefits of real estate investments with Self-directed IRA

The potential risks of real estate investments with Self-directed IRA

The Lilypads bottom line

Using an IRA to buy an investment property is not always a cakewalk.  Before investing, you must be familiar with the different types of individual retirement accounts. It’s a high-risk investment where the property value may drop.

Moreover, the yearly maintenance cost may incur penalties if your income and IRA contribution limit doesn’t cover repairs. So, before investing your IRA in real estate you must acquaint yourself with each of its aspects.

Hence, it is advisable that investors who do not wish to participate in real property management activities must refrain from IRA. Other securitized real estate strategies like REITs that allow indirect property ownership are also held in regular IRAs.