Self directed retirement accounts continue proving their value by providing full control of your retirement funds, with real estate leading the way as the best understood and most preferred self directed asset. The Self Directed IRA real estate account is the easiest way for everyone to invest in real estate. It is also the most proven wealth-building asset class of all time.
When Buying real estate in your self directed IRA, you can invest in property of all types. Including single-family houses, apartment complexes, commercial properties, raw land, and uncounted other variations of real estate ownership.
Owning single-family rentals is the most common way to hold real estate but there are many other possibilities. For instance, a Self Directed IRA real estate account can partner with others to own large apartment complexes. Some investors prefer to lend money in the form of a mortgage secured by real estate and others prefer mineral rights. The list of possibilities is extraordinary, so let’s explore the wealth creation process that a Self Directed IRA real estate account offers…
The Pros and Cons of Buying Real Estate In Your Self Directed IRA
PRO #1 begins with flexibility. One of the first things to know is that the tax code and the IRS (internal revenue service) do not limit what people can invest in. Instead, the rules define what you cannot invest in, which is a very short list (we get to that below). Real estate is definitely an allowable IRA investment. Because there are very few investment rules, the IRS does not have specific guidelines for Self Directed IRA real estate. Instead, the guidelines are kept at the most flexible level that the IRS defines as a Traditional IRA and a Roth IRA. Both of which allow real estate investments.
However, there are very big differences between IRA accounts that are controlled by institutions or financial advisers (Wall Street Greed investments), and a self directed IRA that gives you full control of your investments. It’s only when you take control with your Self Directed IRA real estate account that alternative investments become possible. The Self Directed IRA opens an entirely new world of investment possibilities including acquiring the perfect home for your retirement that you can hold today while earning tax-advantaged income.
That is only one of the PROs that come with your Self Directed IRA real estate account. You can buy any investment property today to gain immediate tax advantages while allowing the income to grow your retirement account. When you purchase these investments through your Self Directed IRA real estate account, they must remain an income producing (not for personal use) until you begin taking distributions at retirement. Your wealth-building strategy today is to minimize taxes, earn a healthy retirement income, and gain financially from the appreciation in real estate value over many years.
With the financial freedom that comes from a Self Directed IRA real estate account, you will have more options when you retire. For instance, you could sell the real estate for a lump sum that allows you to do anything you want during retirement. Or you could continue collecting the rental income for a steady retirement income stream and still leave a real estate legacy to your heirs! The choices are yours and the PROs are many!
PRO #2. Big tax benefits. As you have probably realized by now, a Self Directed IRA real estate account is different from normal IRA accounts. That is where the major pros come from. You get the same tax deduction benefits plus all the income that real estate earns also goes into your retirement account with the same tax benefits. You’ll want to learn the difference between a Traditional IRA and a Roth IRA and which type of tax benefits best fit your needs.
A Roth IRA uses after-tax contributions that you don’t deduct from your taxes in the year you contribute. Instead, your earnings grow tax-free so that when you take distributions in retirement, you won’t owe any taxes on the long-term and compounded earnings. Your retirement home could be a splendid example of this.
If you bought it with Roth funds today for $300,000, you could distribute it tax-free for your personal use at retirement when the value could well be $700,000 or more (while earning retirement income for you between now and then). On the other hand, a Traditional IRA allows you to deduct your contributions in the tax year that you make the contributions to reduce the taxes you owe today.
Earnings then grow and compound tax-deferred, until distributions you take in retirement are taxed based on your retirement tax rate. Either way, there aren’t any other opportunities to invest in real estate in such a powerful tax-sheltered way. Full tax-control of your retirement investments is a big PRO that comes with your Self Directed IRA real estate account.
PRO #3. Investing in what you know. This is the potential for a high rate of return from your self directed investments. Most people have a much better understanding of real estate than they do of stocks, bonds, and foreign currencies. You trust that you’ll get a dependable and high rate of return from a rental in a stable-income community. You also know better than to buy swampland in Florida. But do you know which Wall Street stock is going to be devastated by a global event next week? The truth is that not everyone will make a killing with real estate but people do understand real estate investing much better than any other type of investing.
PRO #4. Have full control of your retirement account. Checkbook control for timely decisions is one more PRO that comes with your Self Directed IRA real estate account. The freedom to directly write checks from your retirement account allows you to make time-sensitive investments. It also lets you control funds moving in and out of your retirement account – for instance paying a contractor for remodeling or repairs to a rental house. Checkbook control is accomplished through a limited liability company (LLC).
With an LLC, you do not have to file paperwork with an IRA account custodian asking them to cut a check on your behalf – and you also don’t pay a custodian fee. Depending on their business hours and workload, waiting for a custodian to act on a time-sensitive transaction can be frustrating and cost you a great investment opportunity. Setting up an IRA-LLC to give yourself checkbook control also has other benefits.
PRO #5. Legal protections that you gain through an IRA-LLC could prove highly valuable. Think about it for a moment. For most people, their home is their most valuable asset. But with a Self Directed IRA real estate account, your retirement assets could quickly become your most valuable assets. Assets worth protecting.
As a Self Directed IRA real estate owner, it would be wise to consider an IRA-LLC for the same asset protection that many individuals use LLCs for in their other business activities. The reason is an LLC prevents the creditor of the LLC from being able to pursue the owner of the LLC (in this case, the self directed IRA). An IRA-LLC is an LLC owned by the IRA.
The LLC owns and operates the investments and the liabilities similar to an LLC used by an individual for business. For example, instead of the self directed IRA taking ownership of a rental property directly and leasing it to a tenant, the IRA-LLC would take title to the property and would lease the property to the tenant. Any claims or liabilities that arise are the responsibility of the LLC. The LLC laws prevent a creditor from going after the LLC owner (in this case, the IRA, or you as the IRA owner). You may also have additional protection from certain types of court orders, depending on the state in which you live.
PRO #6. Being an active participant. Self Directed IRA real estate owners can be more active in their retirement investments. There are a few restrictions that we go into in the next section but a self directed IRA real estate strategy can be more hands-on. Unlike a small proxy vote for the board of directors of a major corporation, full control of your assets means you not only decide which real estate to invest in but also how the property will be managed.
You can decide what house remodeling will be the most profitable, how much rent to charge, whether to hold onto a particular house, or whether to sell for a better opportunity.
You make these and all other decisions affecting your retirement funds. Many other PROs come with a Self Directed IRA real estate account but let’s be fair by looking at the CONs to having full control of your retirement…
CON #1. More paperwork. Full control means that you deal with more paperwork. With a Self Directed IRA, you are responsible for the due diligence before making a real estate purchase and all of the paperwork to close deals. When you use an IRA-LLC, you don’t have a custodian looking over your shoulder to make sure all of the paperwork is correct. Something that a custodian does is keep your transactions in line with IRS rules.
We cover those rules next but if you go too far afoul of the rules, the IRS could disqualify your IRA and force it to be distributed before you retire. You would face an unexpected and unwanted tax bill from the distribution. It’s crucial that you learn the rules and regulations for buying, financing, managing, and selling any property you invest in through your Self Directed IRA real estate account.
CON #2. Unrelated debt-financing income (UDFI). Fortunately, we offer a solution to this with a Solo 401k retirement account. However, if you use a mortgage or other financing to purchase real estate with an IRA real estate account, the portion of earnings attributed to the financing is taxable in the year the earnings are received. Still, you will receive tax-preferred treatment for the portion of earnings that are financed by your Self Directed IRA real estate account.
For example, let’s say you invested in a $200,000 home using $100,000 of your IRA funds and a $100,000 mortgage. Fifty percent of your net income would be considered UDFI and taxable since that’s the portion of the purchase you made using debt. As the debt is repaid, the taxable percentage decreases until your IRA owns 100% of the property. At that time, the UDFI penalty goes away. Again, the Solo 401k offers a solution to this tax penalty
Con #3. Possible market liquidity challenges with real estate. When you have IRA real estate, you can’t simply call up your stockbroker and tell him/her to sell your stocks and deposit the money in your account tomorrow. It takes time to sell real estate and there are closing costs involved. Most real estate investments are made for the long term. A Self Directed IRA real estate account can be ideal for your long-term retirement plans but should not be planned on for emergency costs or next year’s vacation.
Now you know that the PROs of a Self Directed IRA real estate account far outweigh the CONs, but you do need to understand the rules for self directed retirement accounts before deciding to take full control of your financial future.
The two most important sets of rules that you need to understand involve disqualified people and prohibited transactions. The main point of these rules is for the transactions in your IRA to be arm-length from your personal finances and the finances of people likely involved with your personal finances. The IRS takes these rules seriously.
If you violate these rules, you can expect the IRS to disqualify your IRA and force it to be distributed before you retire. You would face an unexpected and unwanted tax bill from the distribution. Prohibited transactions mostly involve transactions with disqualified people. Knowing the people that your IRA cannot do business with is the place to start. A disqualified person is:
- Your spouse.
- Any fiduciary of the retirement plan (person who makes investment decisions for the plan).
- Companies that provide services to the IRA.
- Your lineal ascendants (parents, grandparents) or descendants (children, grandchildren, etc.), and spouses of your lineal descendants (son-in-law, daughter-in-law, etc.).
- A corporation (or other entity) that is 50% or more owned (directly or indirectly) by yourself, your spouse, or any of your lineal ascendants or descendants.
- An officer, director, 10% or more owner, or highly compensated employee of the corporation named above.
- A 10% or more (in capital or profits) partner or joint venture of the corporation above.
IRS regulations don’t allow transactions that are considered “self-dealing,” and they don’t allow your Self Directed IRA real estate account to buy property from or sell the property to any disqualified person, including yourself, the family members listed, and others. Something that you might not notice at first glance is that transactions are allowed with many other relatives; including uncles, aunts, cousins, sisters, brothers, step-brothers, and step-sisters. The point being is that list of disqualified people is short.
There are specific prohibited transactions for the same “self-dealing” reasons and excluding the same disqualified people. Prohibited transactions are:
- A transfer of plan income or assets to, or use of them by or for the benefit of, a disqualified person.
- Any act of a fiduciary by which plan income or assets are used for his or her own interest.
- The receipt of consideration by a fiduciary for his or her own account from any party dealing with the plan in a transaction that involves plan income or assets.
- The sale, exchange, or lease of property between the plan and a disqualified person.
- Lending money or extending credit between a plan and a disqualified person. (If you want to borrow money from your retirement account, you should consider a Solo 401k)
- Furnishing goods, services, or facilities between a plan and a disqualified person.
The all-encompassing point of the rules is to preserve and protect your Self Directed IRA real estate account. These prevent you and others from taking assets out of the account before your retirement. For instance, you are not allowed to divert rental income to your personal use just because you have a few bad months financially.
The rules are intended to preserve your retirement funds for your retirement. Not only does that mean not diverting rental income, it includes not being able to sell property that you personally own to your retirement account. Selling personal property to your retirement account would be a way of accessing your retirement funds before you retire. There are other implications here such as not using IRA property as your personal vacation home.
Furnishing goods, services, or facilities is another important rule to understand. At its most basic, it means you cannot work on the rental properties (or any real estate) owned by your IRA. That means not even putting a fresh coat of paint on the walls between tenants. It also means not replacing the roof yourself or doing any other work on the property.
There are a few other rules that your self directed IRA must follow:
- Your IRA cannot own collectibles. Examples of collectibles include:
- Wine and/or other Alcoholic Spirits
- Collectible coins (such as numismatic precious metals)
- Precious gemstones
- Non-fungible tokens
- Self Directed IRA real estate must be titled in the name of the IRA.
- All property expenses must be paid from your IRA – and income must return to your IRA.
You’ll find more details, examples, and ways to prevent mistakes from happening in this prohibited transactions article.
Almost all rules involving Self Directed IRA real estate are easy to understand and follow. One that falls into a gray area involves rehabbing and flipping houses. The reason is that flipping is generally considered an active business rather than a passive retirement transaction. If flipping houses is an important reason you are considering a Self Directed IRA real estate account, you should first read this article about passive income.
You might be thinking that an easier way to grow wealth with real estate is by directly tapping into your retirement account. Every situation is different but in almost every situation tapping your retirement account to invest in real estate is not a good idea. The exception would be a withdrawal used in a qualified first-time home purchase if the house will be your personal residence because there is an IRS exception for this. Otherwise, your tax losses will be compounded in multiple ways with an IRA withdrawal to purchase real estate.
- The IRS will impose a 10% tax penalty on the amount withdrawn before you reach retirement age. For example, if you withdraw $200,000 from your IRA, the tax penalty will be $20,000.
- The amount withdrawn will become taxable income for you in the year of the withdrawal.
- The rental income will count towards your personal income tax every year you own it personally.
- The rental income will not be added to your Self Directed IRA real estate account tax-deferred or tax-free.
- You will lose the opportunity to grow and compound the amount you withdraw tax-deferred or tax-free until you retire.
If you are a first-time homebuyer, there can be a good reason to withdraw the money needed from your IRA. Otherwise, for tax purposes, your investment strategy should be with a Self Directed IRA real estate account.
Nabers Group is the leader at providing ways to invest in real estate in the most tax-advantaged ways. We are pioneers of the Solo 401k. For maximum tax benefits, the Solo 401k is your best choice but it does have the self-employment requirement that the Self Directed IRA real estate account does not have. Your situation is unique but besides the largest allowable contributions, another benefit the Solo 401k offers is the ability to combine retirement funds with your spouse.
The Solo 401k allows both spouses to co-invest in real estate in the Solo 401k Trust. For others, the Self Directed IRA real estate account offers the best opportunity to grow wealth through real estate investing. It can be through rental properties, commercial real estate, apartment buildings, mortgages, tax liens, and other investments secured by real estate. There are multiple ways to get started.
Setting up a traditional or Roth IRA for your IRA LLC is easy. When you set up your IRA LLC with us, we make the process smooth, compliant, and easy for you so you can get on with your investing and doing deals! Our team of experts will help you swiftly and thoroughly complete your IRA application so your account can be opened in just a couple of business days.
You can set up your Self direct IRA today and make tax-advantaged contributions throughout the year. Or your Self Directed IRA real estate account can receive rollovers from any other “defined contribution” type of retirement account such as another IRA, 401(k), 403(b), 457, SIMPLE IRA, SEP IRA, Keogh, etc. We’ll also set up your LLC so that you have checkbook control over your investments and ultimately your retirement.
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The most flexible level that the IRS defines