Self-Directed IRA for Real Estate

IRAs typically own investments like stocks, bonds, exchange-traded funds (ETFs) and mutual funds. But what if you want your IRA to invest in income-producing residential real estate such as a single-family house that you rent out?

The IRS does allow you to own this sort of property in an IRA, and doing so can be a smart way to diversify your retirement portfolio. Real estate prices are not correlated with the stock and bond markets, so owning real estate reduces your portfolio’s overall risk. At the same time, you can gain a steady stream of income from tenants flowing back to the IRA…you can raise rents if inflation rises…and the value of your property typically appreciates so you make a profit when you sell.

But there can be a problem: The custodians of most IRAs are major brokerage firms such as Fidelity, Schwab and Vanguard, and they don’t allow you to own real estate properties in your IRA. Reason: It is more profitable and less complex for them to offer and manage only traditional liquid investment products.

Solution: If you want to own real estate, you can open a self-directed IRA, also known as a SDIRA, with a custodian or administrator who specializes in alternative assets. 

This type of investing isn’t for everyone. There are pitfalls to owning real estate in an IRA. SDIRAs have lots of rules, red tape and prohibited transactions that can result in severe tax consequences.

Bottom Line Personal spoke to SDIRA expert Tony Unkel about how to make these real estate IRAs work for you and, even more important, how to avoid missteps….

WHAT IS A SELF-DIRECTED IRA FOR REAL ESTATE?

SDIRAs operate under nearly identical rules and regulations as regular IRAs. You can open a traditional or Roth SDIRA, and you can do Roth conversions.  Any transactions within an SDIRA are not taxable. You pay taxes only when you take distributions, which are taxed at ordinary income tax rates (distributions from a Roth SDIRA are tax-free). The IRS allows you to contribute to both a regular IRA and an SDIRA in a given year as long as your total contribution for the year does not exceed the IRA contribution limit. Finally, you can roll over any existing IRAs and 401(k)s into an SDIRA, which is the way most of these accounts are initially funded.

It’s easy to open an SDIRA online with a custodian that allows for real estate investments. The custodian is responsible for handling transactions and managing paperwork and reports to the IRS. You can ask your financial advisor to recommend a custodian or find one in the list of top custodians at North American Savings Bank’s website (NASB.com, search for “self-directed IRAs”).

Different custodians have varying fee structures—some charge flat annual fees, while others have fees based on account value or activity. Example: The custodian might charge an annual recordkeeping fee of a few hundred dollars, plus an assets-under-management (AUM) fee of 0.15% of the total asset value.

Once your account is funded, you can find a property, negotiate a price and ask your custodian to send the funds. The property is titled in the name of your IRA, not your own name.

Although many SDIRAs invest in rental properties, the IRS allows you to purchase a variety of commercial real estate including shopping malls, parking garages, mobile-home parks, office buildings, assisted-living facilities and recreational facilities.

PROHIBITED TRANSACTIONS

The critical difference between an SDIRA and a regular IRA is an extra layer of IRS regulations called “prohibited transactions.” Other IRAs also are subject to prohibited transaction rules, but they often don’t apply with publicly traded stocks and bonds. Violating these rules, even accidentally, results in major tax penalties. Your entire SDIRA will be disqualified, effective the first day of the year in which the prohibited transaction occurred. That means you will be required to take a taxable distribution for all the assets in the SDIRA. If you are under age 59½, you also may face a 10% early-withdrawal penalty. Prohibited transactions include…

You cannot self-deal

Your SDIRA cannot purchase property that you own or sell property to you. You also are not allowed to sell or purchase from certain other “disqualified individuals,” including…

Anyone with discretionary authority over your SDIRA assets such as a custodian or investment advisor.

Certain business entities such as a corporation or partnership in which 50% of more of its ownership is held by a disqualified person.

Direct family members such as your spouse, parent, children, grandchildren and their spouses. (Note: The IRS does allow you to transact with other family members such as your siblings, aunts, uncles, cousins and former spouses.)

You and disqualified individuals cannot make personal use of any property in the SDIRA

Examples: You can’t rent office space in a building you own in your SDIRA. You can’t buy a multifamily building and let your college-age child live in one of the units, even if he/she pays rent. You cannot purchase a ski condo and spend even one night there yourself.

You and disqualified individuals cannot perform personal work on the property

That includes mowing the lawn, making repairs and/or collecting the rents from renters. All services must be outsourced to a third party such as a property manager and landscaping service.

All property expenses must be paid from your SDIRA…and all income must return to your SDIRA

eep enough cash in the SDIRA to cover the cost of property maintenance and renovations, as well as property taxes, condo association fees, utility bills, etc. Likewise, all rents or other income generated by the property must go to the SDIRA, not to a personal account.

CAVEATS TO USING SELF-DIRECTED IRAs

Your custodian doesn’t provide real estate investment advice

You will have to find and evaluate potential properties and perform your own due diligence to avoid scams, underperforming assets and problem tenants. If you don’t have the expertise or experience, you can hire an advisor or use the cash in your SDIRA to invest in private entities that pool funds to invest in real estate, such as limited partnerships and limited liability corporations.

You lose some valuable tax benefits available to residential real estate owners

Because SDIRAs do not pay taxes, you can’t take advantage of the significant deductions associated with owning certain residential property. Examples: You cannot subtract mortgage-interest payments from your personal taxes, nor take property-tax deductions or depreciation. And upon your death, there is no step up in basis for real estate held in a SDIRA—if you leave the SDIRA to your heirs, they pay tax at their ordinary income tax rates as they would on any distributions. If you left them the property in your will, the tax basis of the inherited property is adjusted to its fair market value on the date of your death.