Learn how to invest in real estate using a self-directed retirement account.
Real Estate & Self-Directed IRAs
Robert, thanks for the great question. Yes, you can buy real estate using a special kind of retirement account that’s self-directed. A self-directed IRA allows individuals to diversify their retirement portfolio by putting money into different types of sophisticated investments besides the typical ones, such as mutual funds and stocks. For business owners there are other options, such as a self-directed 401(k), but I’ll just refer to IRAs in this episode since we’re talking about individuals. And just so you know, IRA used to be short for Individual Retirement Account, but now the Internal Revenue Service calls it an Individual Retirement Arrangement.
You can buy any kind of foreign or domestic real estate in self-directed retirement accounts, such as vacant land, houses, condos, commercial properties, foreclosures, and rental properties, for example. You can also make other types of investments besides real estate, such as capital for private businesses, notes, tax liens, and gold. The only two types of investments that you can’t purchase in a self-directed retirement account are life insurance contracts and collectibles, such antiques, art, and cars.
Self-directed IRAs have the same basic rules as regular IRAs. If you’re not sure what those are, I’ll include some resources for you in the show transcript at moneygirl.quickanddirtytips.com. One of the main rules of all government-sponsored retirement accounts is that assets generally can’t be withdrawn from the account until you reach age 59½, without triggering a big penalty. However, self-directed retirement plans also have additional restrictions, especially when it comes to owning real estate. So if you like the idea of buying real estate with your IRA money, you’ll need to brush up on the various account restrictions to protect yourself.
The limitations of self-directed retirement accounts were established to prevent assets these accounts hold from benefiting the account owner in any way until he or she reaches retirement age. You see, according to the IRS, the funds in a self-directed retirement account are only meant to benefit the account—not the account owner who’s investing them. It’s as if you’re attempting to make profitable investments with someone else’s money until you celebrate your 59-and-one-half birthday.
If you use money or assets held in your self-directed IRA for personal benefit, before the law allows, you’re engaging in what’s called a “self-dealing” transaction. That violates the rules and puts the tax-deferred status of an account in jeopardy. That could mean having to face a massive tax bill.
Real Estate Use Restrictions
Consider this example: You’re 40 years old and decide to use $50,000 in your self-directed IRA to pay cash for some vacant land on a small lake. You want to purchase the lot now, while it’s still for sale at an affordable price. You intend to take ownership of the property and build a cozy cabin on it once you retire.
Until then, you plan on going to the lot on summer weekends to launch your canoe and do some fishing. Sounds innocent enough, right? Well, that plan would actually be a bad idea. Because you purchased the land with IRA funds, you’d be violating the tax law by deriving any personal benefit from the property before retirement age. If the IRS were to wise up to your personal use of the land, the entire value of the property could be considered a non-qualified IRA distribution. That means the full value of the property would be subject to income tax plus an early withdrawal penalty since you’re younger than age 59½. Dare I say your use of the property would look “fishy” to them?
Real Estate Rental Restrictions
Here’s another scenario: You want to buy a beach house with your self-directed IRA and rent it out for income until you can use it as a second home when you retire. That is completely legit as long as you follow the rules. The major restriction for your beach house is that until you retire, you can’t use it as a vacation property, even for a weekend. Nor is it permitted to rent it out to certain close relatives. You aren’t even allowed to pay yourself the profits generated by an IRA’s rental property—those must go back into the retirement account. So, you can see that investors must be extremely careful about how they use the funds and assets held in their self-directed IRA.
Getting a Self-Directed IRA
Getting started with a self-directed IRA is pretty easy. You can set it up with new money or transfer funds in from an existing regular IRA. Custodial firms, insurance companies, and banks can open up the account and act as your trustee. They handle the disbursement of funds or collection of profits for the IRA, but they might not give you investment advice or even handle real estate transactions. For that reason, it’s best to find an administrator with specialized real estate experience. I’ll include links to some custodial firms to check out at the end of the show notes.
The Cost of a Self-Directed IRA
The cost of having a self-directed IRA varies. Some administrators charge according to the total value of assets in the account. For example, if your self-directed IRA is worth $75,000, the annual fee might be 1% or $750. Some firms charge a flat fee per asset you hold in the account, while others charge a transaction fee each time they handle a task for you.
I don’t recommend buying property with funds in a self-directed retirement account if you’ve never dabbled in real estate before. As someone who’s been a real estate investor for decades, I can tell you that making good real estate investments can be tough enough, without the added pressure of complex IRA restrictions! But when you gain some experience and understand what you can and can’t do with real estate in an IRA, it can be a fantastic vehicle to build your wealth. And that’s especially true right now, since real estate in many areas is selling at bargain-basement prices.
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