For individuals who are interested in commercial real estate, there are traditionally two ways to invest.  A property can be purchased directly, which provides the owner with complete control over the asset identification, selection, financing, and management processes.  Or, an indirect investment could be made by purchasing shares in a REIT or allocating capital to a private equity real estate investment like the ones our firm offers.

There is, however, a lesser known third option that is a combination of these methods and it can provide significant tax benefits for the investor.  It can be done by opening a specialized type of retirement account known as a “Self-Directed IRA” and using the funds within it to invest in commercial real estate assets.

What is a Self-Directed IRA?

A Self-Directed IRA (SD IRA) is a specialized type of Individual Retirement Account (“IRA Account”)  that allows the owner to invest in a variety of alternative investments that are normally prohibited in a “regular IRA.”

Where traditional IRAs typically contain stocks, bonds, money market accounts, ETFs, and mutual funds, a SD IRA may contain these in addition to alternative assets like:

  • Commercial real estate, including undeveloped or raw land and rental properties
  • Promissory notes & tax liens
  • Gold, silver, other precious metals, and cryptocurrency
  • LLC Membership interests

Because the IRA is “Self-Directed”, the owner of the account is responsible for adhering to a number of rules that govern its use:

  • Type:  A self-directed IRA can be a Traditional IRA or a Roth IRA.
  • Contributions:  Self-directed IRAs are subject to contribution limits of $6,000 for individuals under the age of 50 and $7,000 for those over 50 (per 2020 rules).
  • Custodians:  Self-directed IRAs must be administered by an IRA custodian, which can be a bank, brokerage, federally insured credit union, savings and loan association, or other entity approved by the IRS.
  • Prohibited Investments:  A self-directed IRA cannot be used to make an investment in a prohibited asset class.  These include collectibles like: artwork, rugs, antiques, gems, stamps, coins, and alcohol.
  • Prohibited Transactions:  A self-directed IRA cannot be used to engage in a prohibited transaction, which includes the transfer or use of IRA assets by or for the benefit of a disqualified person, self-dealing, excess contributions, early distributions, and the accumulation of excess amounts.

When used correctly, there are a number of benefits to using a Self-Directed IRA to invest in commercial real estate.

Benefits of Using a Self-Directed IRA to Invest in Commercial Real Estate

Beyond the broad benefits of investing in commercial real estate in general, there are a number of benefits to specifically using a self-directed IRA to do it:

  • Investment Options & Portfolio Diversification:  Self-directed IRA funds can be used to invest in a variety of commercial real estate assets including rentals, fix and flip properties, land, mortgages, REITS, and non-publicly traded ownership interests in LLCs that own commercial property.  All can add an element of diversification to the traditional stock/bond portfolio.
  • Tax Free or Tax Deferred Earning:  Because the investment is held in a tax advantaged account, earnings are allowed to grow tax free or tax deferred.  In addition, the account owner can control the tax liability on the back end through the timing of distributions once they reach a certain age.
  • Safeguarded From Debt Collectors:  Investments held in a self-directed IRA are safeguarded from debt collectors, which means that they cannot be accessed to pay other past due debts.
  • Can Be Passed on to Heirs:  As long as a beneficiary is named, funds in a Self-Directed IRA can be passed to heirs with the tax advantages in place.
  • Easy to Open:  Self-Directed IRAs are easy to open and there are a number of options from which to choose a custodian.
  • Regular Contributions:  Like traditional IRAs, self-directed IRAs can be funded with regular contributions to the account.
  • Rollovers:  Funds from an existing retirement account, such as a 401k, can be transferred or rolled over into a Self-Directed IRA.

While the benefits can be significant, there are also a number of risks to be aware of.

Risks of Using a Self-Directed IRA to Invest in Commercial Real Estate

Beyond the general market risk of investing in commercial real estate, there are a number of risks to be aware of when using a self-directed IRA to do it specifically:

  • Prohibited Investments & Transactions:  If self-directed IRA funds are used in a prohibited investment or transaction, the tax benefits can be nullified.

A prohibited transaction is one made between the IRA and a “disqualified person,” who is a:  fiduciary of the plan, person providing services to the plan, employer, or an employee organization whose members are covered by the plan.

Prohibited investments include: artwork; rugs, antiques, metals, gems, stamps, coins, alcohol, or other tangible property. If IRA funds are used in a prohibited investment, it may become taxable.

  • Custodian Experience:  Self-Directed IRAs must be administered by a custodian, but the experience, advice, and level of customer service can vary widely from one custodian to another.  Investors should perform their own due diligence to find the best custodian for them.
  • Fees:  The fees charged for the administration of a self-directed IRA can be expensive.  When combined with the fees charged by investment managers, they can materially impact returns.
  • Illiquidity:  There are two levels of illiquidity when using a self-directed IRA to invest in commercial real estate.  First is the illiquidity of the investment itself, which could require a funding commitment of 5-10 years.  Second is the funds within the IRA, which cannot be distributed tax free until the owner has reached a certain age.

Interested In Learning More?

First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.

We have a significant amount of experience in dealing with investors who are using self-directed IRAs.  Whether you’re just getting started or searching for ways to diversify your portfolio, we’re here to help.  If you’d like to learn more about our middle market retail investment opportunities, contact us at (800) 605-4966 or for more information.

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