Can I Use My Self-Directed IRA for Real Estate Investing?

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The funds deposited into individual retirement accounts (IRAs) are usually invested in financial products like mutual funds, stocks and bonds — but that doesn’t mean these are the only types of investments to which you’re allowed to allocate deposited funds. That’s especially true when it comes to non-traditional types of IRAs. Self-directed IRAs (SD-IRAs) allow users to invest in (almost) anything they want to.

Plenty of investors choose to use this unique IRA type to invest in real estate as a way of diversifying their retirement portfolios and potentially earning big in the process. To determine if this strategy may be an effective approach for you, learn more about how you can use your SD-IRA to fund real estate investments and how to decide if it makes sense for your portfolio.

What Are Self-Directed IRAs?

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Most retirement accounts run on autopilot. The investor deposits money. A brokerage invests it. The investor reaps the benefits with earnings. All IRAs have an appointed custodian, which is a financial institution that manages the funds in accordance with standards dictated in ERISA, the Employee Retirement Income Security Act of 1974, which makes tax-deferment on the money in IRAs possible. In exchange for deferring taxes, the government wants to know that the money is actually being invested. This is why the IRA custodian is tasked with ensuring that investment activity involving your IRA always adheres to IRS and other government regulations.

The money in traditional IRAs is typically put towards relatively common types of investment products — stocks, bonds, mutual funds, certificates of deposit and so on — and a brokerage makes decisions on your behalf about how the IRA’s funds are invested. SD-IRAs, on the other hand, don’t limit you to using your IRA funds to invest in everyday financial products, and there isn’t a brokerage firm making any decisions about how the money in your IRA is invested. Instead, you’re responsible for making those decisions.

SD-IRAs still require custodians to prevent you from violating any rules, but they allow you to invest the money deposited into your IRA in a much wider variety of assets and non-traditional investments — as long as the custodian agrees to do so. In some SD-IRAs, the investor has direct access and control of the money. In other SD-IRAs, a custodian has access to the money, but the investor still determines how the money is invested. Different custodial companies offer different products.

An SD-IRA gives you the opportunity to make your portfolios more diverse, and it also grants you more control over how your money is spent. These accounts can be used to invest in gold, franchises, private businesses and even real estate. And having all these options can open up more opportunities for you to build wealth to support your lifestyle during retirement.

How to Set Up a Self-Directed IRA

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The simplest way to set up an SD-IRA is to contact a professional custodian. This could be a firm, a bank, a financial advisor or an approved non-bank trustee. It’s best to find a firm that specializes in SD-IRAs and real estate investing in particular. Professionals with expertise are likely to be aware of the specific regulations that apply to these unique retirement accounts. Whichever custodian you select, be sure that the organization is approved by the IRS. Although the account is self-directed, you still must obtain the custodian’s approval to spend money, which can be a lengthy process. You’ll want to work with a company that understands markets and can process transactions efficiently.

Real estate is a fast-paced industry, and many investors want to avoid the ample amounts of paperwork involved in getting approval from a custodian. However, there’s a second method of using an SD-IRA called a checkbook IRA. In practical terms, the investor can write checks out of a specific checkbook to make investments using the SD-IRA’s funds. The investor must create a limited liability company (LLC) and legally appoint themselves as the manager of that LLC in order to invest using an SD-IRA this way. While the investor cannot make any money from the LLC during the life of the investment, the investor has full authority to write checks. These checks allow IRA funds to pay for approved investments and investment expenses.

Regardless of the way an SD-IRA is set up, it’s still monitored and subject to auditing by the IRS. Especially if you’re using a checkbook IRA, you should be careful to follow IRS standards and stay abreast of any updates. An SD-IRA that doesn’t abide by IRS guidelines could be subject to immediate taxation and other penalties.

How to Buy Real Estate With a Self-Directed IRA

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Once your SD-IRA is set up in the way that suits you best, the next step is to invest in real estate. Real estate investing, like any other investing, takes research and a certain level of skill, along with knowledge about market conditions. It’s acceptable to use SD-IRA funds to buy homes for resale and to generate rental income. SD-IRA funds can be used for the purchase and any upkeep involved in maintaining the home or making it more marketable to the public. This can include paying professionals, such as contractors or real estate agents.

Remember that IRAs are only tax-deferred when you’re not making withdrawals from them; the money you put into them comes from pre-tax earnings. Any transaction or action that benefits you as the investor prior to retirement age is considered the same as withdrawing funds from a regular IRA prior to turning 59.5 years old. If early withdrawal happens, all of the money in the SD-IRA is subject to a 10% penalty, and the tax-deferred status expires immediately.

Here are some examples of ways that an investor can err: If an investor chooses to work on their own investment property, they cannot pay themselves for the work. Investors also cannot use SD-IRA funds to buy real estate that a family member owns. An investor cannot live in any of the properties purchased with SD-IRA funds, and they cannot rent or sell to family members. In addition, it’s illegal for investors to pay themselves or a company they own for making improvements to an investment property purchased with their own SD-IRA funds. That action could trigger immediate taxation of the funds in the SD-IRA.

Is Real Estate Investing With a Self-Directed IRA Right for You?

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An SD-IRA can offer excellent long-term earning potential, perhaps even more than you might earn going the traditional route, but there are some risks involved and a higher level of strategizing required. Because you determine which investments your SD-IRA is used to fund, the value of the account corresponds directly with your skills and decisions. All investments come with inherent risk, but real estate markets can be especially volatile. If you’re not already somewhat experienced in real estate investing, it may not be a wise decision to use your retirement fund as a way to learn the ropes, so to speak.

It’s also important to keep in mind that, because SD-IRAs are tax-deferred, you’re ineligible for the write-offs and tax incentives that otherwise come along with real estate investment. Depending on the scope of investment, the benefits of tax-deferred status may be less than those of any potential tax write-offs.  

The greater control and earning potential of SD-IRAs for real estate investment is enticing to many investors. If you’re interested in this type of retirement account, remember that it takes a level of skill that may be best gained through experience and there are rules you need to follow carefully to ensure you’re adhering to government regulations. While the potential exists to enjoy greater earnings if the market takes off, there’s an equal chance your real estate investment may lose money. Using your SD-IRA to invest in real estate can be time-consuming as well, so it’s vital to be prepared by getting plenty of experience before you make this leap.