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 real estate.

What is a Self-Directed Real Estate IRA?

A self-directed IRA (Individual retirement account) allows the owner of the IRA to make the investment decisions as to where the money is focused. Traditionally, an IRA is used to invest in publicly traded stocks, bonds and mutual funds. Savvy real estate investors can focus their investments for themselves using a self-directed IRA (SD IRA). A “Real Estate IRA” is just an self-directed IRA that primarily focuses on real estate investments. A self-directed real estate IRA places retirement funds in different types of real estate-related assets.

What Type of Real Estate Can Be Invested in With a Self-Directed IRA

You can purchase several different types of real estate inside of an self-directed IRA. Here is a general list:

  • Residential – Many self-directed IRAs are single-family homes and multi-family units. Rental income is generated by renting these properties.
  • Commercial real estate is another great way to generate long term rental income. The real estate investments include a broad range – from a grocery store, an office building to a baseball field.
  • Mortgage Notes are an indirect way to invest in real estate. You are a real estate lender who uses your savings to help others purchase homes while making a profit for yourself.
  • Offshore real estate investments are for investors who want the freedom to invest in foreign real estate markets and to take the tax benefits associated with overseas investments.
  • Real estate owned (REO) properties are foreclosed properties that have been taken back by the bank. You can use your self-directed IRA to buy these properties from the bank or the auctions.
  • Apartment Buildings – you can use your SD IRA funds towards an apartment building that you own outright or that you passively invest in with a syndicate. 

The above is a list of the most frequently purchased but there are several other ways to tackle real estate investing using your SD IRA. Building Bonds, Commercial Paper, Improved or Unimproved Land, Tangible Asset Deeds, Tax Lien Certificates, Trust Deeds – there is a lot of opportunity on the table. 

How to Buy Real Estate With a Self-Directed IRA (SDIRA)?

Investing in alternative assets like real estate with your self-directed IRA is similar to a regular real estate purchase. However, there are certain rules and processes you need to follow to do it correctly. Here’s the process of using a self-directed IRA to buy real estate:

  • Open and fund an SD IRA account.
  • Use a qualified self-directed IRA custodian to do this.
  • Find a property to purchase.
  • Do your due diligence and find a property you want to invest in.
  • Give the specifics of the property to your IRA custodian with information of how much money you need, if documents need signing and where to send the funds. You can either fund the entire purchase or a part of it with your IRA.
  • Since the IRA funded the investment, the money, income, and expenses has to be to and from the IRA.

Benefits of Using Self-Directed IRA to Purchase Real Estate

  • Tax-Free or Tax-Deferred Earning – The largest benefit of an IRA, not just a self-directed IRA is the tax free or tax deferred earning. A traditional self-directed IRA allows you to earn on a tax deferred basis, but your withdrawals are taxed. If you use a self-directed Roth IRA, your contributions are taxed, but your earnings grow tax-free.
  • Diversified Investment Portfolio
  • When you are investing through a self-directed IRA, you have a lot of real estate investment options. You can create a healthy level of investment diversification by choosing between rental properties (both residential and commercial), fix n’ flip opportunities, undeveloped land, mortgage notes, REITs, and many more.
  • Secure Future
  • Investments held in a self-directed IRA are more safeguarded from debt collectors. The rules also allow you to leave the savings to your heirs. So, a successful investment using your self-directed IRA could mean a secure future for you and a significant inheritance for your children.
  • Easy to Get Started
  • All you need to do is open an account and fund it. You can fund your self-directed IRA in these ways:
  • Transfer or rollover an existing retirement account, such as a 401(k), into a real estate IRA.
  • Make annual contributions to your account regularly.
  • Start investing when you have collected enough to make an investment. If you don’t have enough cash to invest in real estate on your own, you can partner with other investors.

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.

Self-Directed IRA Real Estate Rules

Below are the 7 self directed IRA real estate rules you should know.

  1. Rule 1: You cannot own the property. Your IRA cannot buy a property that you or a “disqualified person” owns. Your real estate IRA can’t sell the property to you or any disqualified person. This is known as “self-dealing,” and is prohibited.
  2. Rule 2: The property must be uniquely titled. You and your IRA are two separate entities. Investments made with your IRA should be titled in the name of your IRA.
  3. Rule 3: Don’t take any indirect benefits – If your IRA is involved in a transaction that somehow benefits you or a disqualified person, the IRS considers this as an “indirect benefit,” which is not allowed. An example of an indirect benefit is renting space in a building that the IRA owns.
  4. Rule 4: Purchase the property with a combination of funds. You can combine your SDIRA funds with your other funds to purchase real estate. Partnerships and undivided interest are two alternatives that exist.
  5. Rule 5: Pay for expenses from the IRA – Any IRA-owned property expenses, such as renovations, utility bills, property taxes, maintenance fees, and building association fees, have to be paid from your IRA.
  6. Rule 6: If finance used, then pay (UBIT Unrelated Business Income Tax) – If any of the IRA investments use financing, they are required to pay.
  7. Rule 7: Income generated must return to IRA – Any income generated through self-directed IRA-owned property must be returned to your IRA.

Self-Directed IRA Tax Pitfalls to Avoid

  • Self-directed traditional IRA allows your investment to grow tax-deferred, whereas Roth IRA investments grow tax-free. However, you need to follow the rules while investing in real estate with your IRA. If the property is bought the wrong way, it can get your IRA disqualified, making you liable to pay taxes and penalties. If your IRA-owned investment property operates at a loss, you lose the tax benefits. Also, you cannot claim depreciation on IRA-owned real estate.
  • If you are planning to purchase a vacation home, think again! With a real estate IRA, you cannot be involved in self-dealing or carrying out personal transactions. Your family members, too, are prohibited from such kind of transactions. If you buy or sell a property from or to yourself or your family members, you’ll be creating a taxable event.
  • Pay attention to Unrelated business income tax (UBIT) if you are thinking about using a mortgage to purchase the property.
  • When you reach age 72, you must take the required minimum distributions (RMDs) from your traditional IRA. If using IRA money to invest in real estate, make sure there is enough cash left in account to cover RMDs; otherwise, you’ll attract tax and penalties. Roth IRA’s are not subject to RMD’s and this is very important for estate planning.

Self-directed IRA’s allow an investor several alternative investments to choose from. There is certainly more risk to this approach, but it can be an advantage to an investor that can invest in an asset class they are comfortable with, such as real estate. If you have any questions about using a self-directed IRA to invest passively in cash-flowing commercial real estate, please reach out to our team. At First National Realty Partners, we can help you design the commercial investing portfolio that balances potential profits while minimizing investment risks. Our goal is to make it possible for investors like you to get started in these real estate investing opportunities. Contact us any time to learn more about the services that are offered.

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