Investors frequently ask about using retirement accounts to invest in real estate. More precisely, people often want to know if they can directly invest in real estate with retirement funds. While standard retirement accounts like 401(k) plans and IRAs do not allow this level of involvement, an option does exist. Investors can use a self directed IRA, or SDIRA, to pursue these direct investments. As such, we’ll use this article to outline how to use an SDIRA to invest in real estate.
Specifically, we’ll cover the following topics related to SDIRAs and real estate investing:
- What Is An SDIRA?
- How to Use a Self Directed IRA To Invest in Real Estate
- SDIRA Real Estate Investment Options
- Real Estate Investing Risks and Considerations of an SDIRA
- Final Thoughts
What Is a Self Directed IRA (SDIRA)?
In a normal IRA, investors can hold stocks, bonds, certificates of deposit, mutual funds, and exchange-traded funds. However, these retirement accounts do not allow investing in alternative asset classes like partnerships, precious metals, and real estate. With a self directed IRA, or SDIRA, account holders can invest in these asset classes. This serves as the primary difference between a standard IRA and an SDIRA.
As the name suggests, an SDIRA account holder directs the investment decisions in the account. However, the IRS still requires that a separate custodian or trustee administer these accounts. And, whereas most banks offer normal IRAs, only specialized firms provide these SDIRA administration services. Many of these firms also specialize in a particular asset class. For instance, some self directed IRA custodians may only allow investments in precious metals, while others may focus solely on real estate.
Furthermore, SDIRA custodians cannot provide investment or other financial advice to the account holders. As a result, SDIRAs place the research, due diligence, and research burdens on the account holder. These additional burdens mean that SDIRAs are typically only used by savvy investors, people who already have in-depth understanding of the alternative asset class in which they’d like to invest and would like to do so in a tax-advantaged account.
Similar to normal IRAs, SDIRAs offer both traditional (pre-tax) and Roth (after-tax) versions. But, for all of their additional flexibility, the IRS also prohibits several types of investments. SDIRA account holders cannot invest in life insurance, S Corp stocks, collectibles, or any related-party transaction (known as “self-dealing”).
How to Use a Self Directed IRA To Invest in Real Estate
SDIRAs can provide experienced real estate investors an outstanding opportunity for investing in a tax-advantaged retirement account. If interested in pursuing this option, investors should follow these steps:
Step 1 – Confirm SDIRA Funding
Investors have a few options for funding an SDIRA. They can make direct contributions, similar to the contributions for any IRA. However, these are capped at the annual contribution limits, meaning it could take years to build enough capital to support real estate investments. Alternatively, investors can transfer (between the same type of retirement accounts) or rollover (between different types of retirement accounts) funds from a normal IRA into an SDIRA.
Step 2 – Identify the SDIRA Custodian and Fund the Account
As discussed, not all SDIRA custodians specialize in real estate. Investors need to identify a custodian that allows (and, ideally, has experience with) real estate investing. After confirming the custodian, investors need to fund their new SDIRA (NOTE: the IRS has strict rules regarding rollovers, so investors should consult with their CPAs prior to making such a move).
Step 3 – Execute Real Estate Investments
Once investors open and fund their SDIRAs, they can begin making investments. Of note, all purchases will be made in the name of the SDIRA, not the individual account holder. The IRS views these accounts as separate legal and taxable entities. Over the lifetime of the investment, all expenses must be paid from the SDIRA, and all income must go directly into the account.
In the next section, we outline several popular real estate investment options to make within an SDIRA.
SDIRA Real Estate Investment Options
While not an exhaustive list, we’ve outlined several common real estate investment options available to self directed IRA account holders.
Residential Real Estate
This includes single-family homes, townhouses, mobile homes, and multifamily homes up to quadplexes. Many investors have enough cash to purchase these properties outright with SDIRA proceeds, a potential benefit if seeking to avoid A) debt, or B) partnerships.
Commercial Real Estate
Commercial real estate offers far more variety than its residential counterpart. Investors can invest in any type of commercial property with their SDIRA funds (e.g. multifamily, retail, industrial, office, storage, etc.). Due to their larger capital requirements, SDIRA investors typically pursue these deals via a partnership or syndication arrangement.
Land
While not income-producing, some investors choose to purchase land parcels with their self directed IRA funds. This could potentially generate long-term returns if the land is located in the path of an area’s development and is likely to appreciate significantly.
Mortgage Notes
Many investors prefer indirect exposure to real estate, and mortgage notes can provide this. When a lender originates a loan, it may decide to sell the associated mortgage note rather than keep it on its books. Investors can purchase these notes in their SDIRA, collecting interest income in the process. This provides SDIRA account holders an option to indirectly invest in real estate with their retirement funds, as they won’t own the underlying property with this approach.
Real Estate Tax Liens
When a real property owner stops paying taxes, the local tax authority will eventually impose a lien on that property. Tax collectors then create a tax lien certificate and auction it off to investors. When the property owner eventually pays the tax bill, the tax authority will collect it but pass the proceeds (balance plus interest and penalties) on to the tax lien certificate holder. If the property owner never pays the bills, investors may have an opportunity to foreclose on the underlying property.
Purchasing tax liens can provide SDIRA account holders another opportunity to indirectly invest in real estate with their retirement account funds.
Real Estate Investing Risks and Considerations of an SDIRA
While SDIRAs can provide an excellent opportunity for tax-advantaged real estate investing, they also come with certain risks and considerations. Before pursuing an SDIRA real estate strategy, investors should understand the below items:
Unrelated Debt-Financed Income (UDFI)
If investors use debt to finance a real estate investment within an SDIRA, they will face a tax bill for the debt-financed portion of the income (UDFI). For example, assume someone uses $100,000 SDIRA proceeds to purchase a $200,000 rental property, taking out a mortgage for the other $100,000. In this situation, 50% of the rental income would be subject to taxes as UDFI, regardless of the fact that the property is held in an SDIRA. Depreciation can largely negate the tax impacts of UDFI, but investors still need to account for it in their tax planning strategies.
Prohibited Transactions
The IRS imposes strict rules for what SDIRA account holders cannot do, known as prohibited transactions. These could include purchasing a prohibited asset or engaging in a transaction with a “disqualified person.” If an investor breaks one of these rules, the IRS may deem the entire retirement account distributed, potentially creating a massive tax and penalty burden.
Due Diligence
As stated above, the IRS explicitly prohibits SDIRA custodians from providing financial and investment advice to account holders. This means that investors, themselves, must conduct thorough due diligence prior to making any investment decisions.
Fee Structures
Due to the additional administrative burdens of SDIRAs, custodians typically impose more onerous and complex fee structures. These may include one-time set-up fees, annual fees, renewal fees, and investment bill pay/processing fees. Before opening an SDIRA, be sure to have a clear understanding of exactly how and when the custodian will impose fees.
Required Minimum Distributions and Investment Exit Plans
Traditional SDIRAs require investors of a certain age to begin taking required minimum distributions, or RMDs, from their retirement accounts. It’s easy to sell stocks, bonds, and mutual funds to make these distributions. Real estate investments are far less liquid. If investors don’t plan properly, they may run into issues generating enough liquidity to make an RMD. Keeping a portion of SDIRA funds in cash or cash equivalents can prevent investors from facing this sort of problem.
Final Thoughts
SDIRAs offer an outstanding strategy for investing in real estate with a tax-advantaged account. But, even after outlining the above information, we understand that pursuing this sort of investment strategy can seem challenging. If you’d like to discuss different real estate investing options for your unique situation, we’d love to chat! Drop us a note, and we’ll set up a meeting to talk about using SDIRA funds to invest in real estate.