How To Use a Self-Directed IRA To Invest in Real Estate

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Jessica Willens


Summary: In this article, you’ll learn how to use a self-directed IRA to invest in real estate – specifically how to use one to purchase investment property – without penalties! –  in the year 2020 and beyond. Continue reading to learn more. (Note: if you scroll below the introduction you’ll find a handy table of contents. Check it out!


If you are reading this post, you are probably a hard working individual who has begun saving for retirement via an IRA or 401K.

Like people of preceding generations, you have lived through a recession and entered into a time of financial uncertainty. Whether you have built a sizable nest egg or have only saved a small portion of your hard-earned money, one thing is certain, you don’t want to lose it in the volatile stock market!

Having all your money tied to the erratic stock market may be terrifying, especially after the massive financial losses many Americans experienced during the Great Recession. Maybe you want your precious savings tied to something more tangible – something that can’t just disappear overnight, but will still produce solid returns and even passive monthly income.

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In this article, you’ll learn how you can use a self-directed IRA to purchase rental property – without penalties. Whether you want to buy a new investment property(ies) or turn an existing property into a rental home, this post is for you . We’ll help you discover the intricacies of investing in real estate using a self-directed IRA to help you determine if this type of account is the right move for your retirement portfolio. Topics include SDIRA pros and cons, primary benefits, common mistakes and how to avoid them, tax pitfalls, and more. Continue reading to learn more.

What is a Self-Directed IRA

What is a Self-Directed IRA

In the words of Kathy Fettke, Co-CEO and Co-Founder of RealWealth, “A self-directed Individual Retirement Arrangement (IRA) is an individual retirement account that allows the account owner to direct the account trustee to make a broader range of investments beyond stocks and bonds, including: real estate, franchises, precious metals, and private equity. Internal Revenue Service (IRS) regulations require that either a qualified trustee, or custodian, hold the IRA assets on behalf of the IRA owner.”

Like a traditional IRA account, a self-directed IRA (SDIRA) allows owners to defer taxes until retirement age, regardless of the level of returns. However, there are many rules and regulations that real estate investors and account owners must follow in order to receive all of these potential benefits (you’ll learn more about this in the “Self-Directed IRA Rules” section below).

Benefits of Using a Self-Directed IRA to Invest in Income Property

Benefits of Using a Self-Directed IRA To Buy Income Property

Using your SDIRA to invest in alternative assets, such as real estate, will require you to follow important rules and processes. Don’t worry, these rules and regulations will be discussed at length in the section entitled “Self-Directed IRA Rules.” In the meantime, you can learn about a few of the benefits of using a SDIRA to invest in income property, including (1) increased ROI potential, (2) the ability to take control of your financial future, and (3) protect yourself against economic fluctuations.

Benefit 1: Increased ROI potential

The SDIRA gives you the freedom that you need to invest in alternative assets, which means that you will have an increased level of flexibility regarding the amount of risk that you want to incur, as well as the potential for a higher ROI.

Benefit 2: Take control of your own financial future

As its name suggests, a self-directed IRA puts you in charge of your own financial future. With the help of a real estate IRA and a trusted accountant, you can make the right financial decisions for your retirement needs and goals.

Benefit 3: Protect against economic fluctuations

The stock market can be volatile which is why diversification is key to protecting your wealth. The ability to invest in alternative assets, such as real estate, can help you to create a healthy level of diversification, while simultaneously capitalizing on investment opportunities.

To put these benefits into perspective, imagine that you purchase a home for $100,000 and sell it for $200,000. If this property was owned by your SDIRA, then all of the profit would go back into your IRA and subsequently be tax deferred.

Now imagine that you own a home and rent it annually to a tenant for $40,000. If the property was owned by your self directed IRA, once again, your rental income would go back into the IRA and thus be tax deferred. The moral of the story is simple: with the help of a SDIRA you can increase your wealth, while simultaneously enjoying the benefits of tax deferment.

Note: You will eventually have to pay taxes on the tax-deferred income in your IRA when you take cash out. For this reason, many investors choose a self-directed Roth IRA, which is similar to a traditional IRA, except for the way it handles taxes. With the Roth IRA, you actually pay your taxes before placing those funds in the Roth account. Any profits made within the Roth can then be taken out tax free when you retire!How to Use a Self-Directed IRA to Buy Real Estate

A self-directed IRA can be quite complicated, which is why it is important to have a real estate IRA custodian to help guide you. For example, a custodian can help you understand the murky IRS tax code(s), so you can ensure you are following established guidelines to avoid penalties and instead receive the numerous benefits.

If you plan on using a self-directed IRA to purchase investment real estate, then you must be able to generate a sufficient cash flow that will cover any maintenance or repair costs.

Example: Investing in Cash Flow Property with a Self-Directed IRA

Perhaps the best way to show you how to buy real estate using self-directed IRA is with an example. The year is 2007 and Tony was a 62 year-old married man nearing retirement. He had managed to save about $600,000 in his IRA and he was terrified that all of it was tied to the stock market. He didn’t want to lose his entire nest egg and be forced to start all over again at 62.

He decided to self-direct his IRA, just to get it out of the stock market. Initially, he wasn’t sure what he wanted to invest in but with the aid of an accountant and investment advisor he eventually decided to purchase investment properties in the Texas real estate market.

He chose Texas because the market was 26% undervalued at the time; Dallas also had the highest job growth in the country. Yet, it was still possible to purchase nice homes for less than $150,000, and many real estate investors were seeing an average return of 10%after all expenses.

Tony and his wife decided to purchase five homes throughout the Dallas area. After purchasing the properties, Tony and his wife receive a net monthly cash flow of $5,000, which went straight back to their IRA tax-deferred account.

In 2009, Tony and his wife used the money in their SDIRA to purchase a sixth property and subsequently increased their cash flow to approximately $6,000 net per month. In 2011, they purchased a seventh property, increasing their net passive income to $7,000 per month.

This success story highlights the ease with which a self-directed IRA can be used to purchase investment real estate properties. That said, it is important to note that you should always speak with your trusted accountant before making any tax-related decisions. You should also be well-versed on the rules that must be followed, as well as the potential consequences of not using the account correctly.

Finally, you must remember that you will have to pay taxes on any of the money that you take out of your SDIRA.

Self-Directed IRA Risks & How to Avoid Them

Self-Directed IRA Risks & How To Avoid Them

Just because the IRS permits the use of self-directed IRAs to invest in real estate doesn’t mean it is the best option for your retirement savings. There are many SDIRA risks you should be aware of before you start investing, including (1) not performing your due diligence, (2) fraud, and (3) lack of diversification. Continue reading to learn more about these risks and how to avoid them.

Risk 1: Not performing your due diligence

One of the biggest mistakes you can make when purchasing investment property–whether you use cash OR your SDIRA–is not doing your due diligence. Since you are the IRA owner and the property owner, it is your responsibility to complete due diligence.

From researching the current real estate market trends to analyzing the likelihood for future area growth and increases in property value, it is your responsibility to ensure that the investment is sound. With this in mind, if you are not a savvy real estate investor, you will want to seek the help of a trusted professional to help you make the right investment decision.

Risk 2: Fraud

Another risk that you will need to be aware of and avoid is fraud. According to the Securities and Exchange Commission (SEC), there is an increase in criminals attempting to commit fraud against self-directed IRA account holders. The large amount of money that is typically held in SDIRAs is what makes them so attractive to fraud promoters. These individuals might attempt to engage you in a Ponzi scheme or other fraudulent conduct. Avoiding these types of frauds is made easier when you implement the following safeguards:

  • Be sure to verify that all information is accurate within each SDIRA statement.
  • Do not take unsolicited investment offers.
  • Ask questions and be wary if someone balks at your questions.
  • “Guaranteed returns” are often too good to be true. In other words, they are typically run by fraud promoters.
  • When in doubt, ask a professional for help.

Risk 3: Lack of real estate diversification

One of the final risks that you will want to address is a lack of real estate diversification. Just as it is often a poor strategy to own only one stock, it can similarly be a poor investment strategy to own multiple versions of the same type of real estate. By only focusing on the upside potential, you open yourself to a major risk.

Similarly, you need to consider liquidity when making real estate investments with your SDIRA. This means that you might not be able to access the value of your investments when they are needed. For example, your SDIRA might own a $500,000 home; however, until that home is sold, you won’t be able to access its value during your retirement years. Continue reading the next section to learn more about the most important SDIRA rules to follow.

Self-Directed IRA Rules for Real Estate

Self-Directed IRA Rules for Real Estate

As discussed earlier, there are many benefits associated with using a self-directed IRA to buy real estate. The most surefire way to experience these benefits is to follow the rules. The most important of these SDIRA rules include: (1) your SDIRA is not allowed to purchase property that is owned by you or a “disqualified person;” (2) you cannot have indirect benefits; (3) IRA investments must be uniquely titled; (4) a SDIRA can buy real estate in combination with other funds; (5) If financing the IRA is required to pay Unrelated Business Income Tax (UBIT); (6) Any expenses that are related to IRA-owned properties must be paid from the IRA; (7) any income generated via self-directed IRA-owned real estate must be returned to your IRA. Continue reading below to learn more about these rules.

SDIRA Rule 1: Property cannot be owned by you

Your IRA is not allowed to purchase property that is owned by you or a “disqualified person.”

SDIRA Rule 2: You cannot have indirect benefits

You cannot have indirect benefits from property that is owned by your self-directed IRA. These “indirect benefits” might include: renting the garage apartment in a house that your IRA owns.

SDIRA Rule 3: Property must be uniquely titled

IRA investments are uniquely titled, which means that you and your IRA are considered to be two separate entities; as such, investments should be titled in the name of your IRA.

SDIRA Rule 4: Property can be purchase with combination funds

You can purchase real estate in your SDIRA in combination with other funds.. Partnerships and undivided interest are two alternatives that exist.

SDIRA Rule 5: Must pay UBIT if financing.

Any IRA investments that use financing are required to pay Unrelated Business Income Tax (UBIT).

SDIRA Rule 6: Expenses must be paid from IRA

Any expenses that are related to IRA-owned properties must be paid from the IRA. These expenses might include: building association fees, utility bills, maintenance fees, renovations, and property taxes.

SDIRA Rule 7: Income generated must return to IRA.

As stated earlier, any income generated via self-directed IRA-owned real estate must be returned to your IRA. In fact, any and all income that is generated by property owned within your SDIRA is required to be paid directly into your IRA.

SDIRA Tax Pitfalls

Self-Directed IRA Tax Pitfalls

Taxes are one of the biggest benefits of a self-directed IRA; however, they are also one of the potential pitfalls. If you don’t follow all of the associated rules and regulations, you will disqualify the SDIRA and subsequently create a taxable event. Additionally, an IRA-owned real estate investment property can lose tax breaks if the property begins to operate at a loss. For example, you cannot claim depreciation on an IRA-owned real estate property.

Keep in mind that IRAs cannot be used to purchase homes that will directly benefit you, such as a primary or secondary residence. In layman’s terms, your SDIRA real estate investment properties must be held at “an arm’s length.” Self-dealing and personal transactions are not allowed. Additionally, you can’t use your SDIRA to buy or sell property on behalf of a family member, unless of course you want to create a taxable event. UBIT is another potential IRA tax pitfall that must be carefully considered. This consideration is especially important if you are contemplating using a mortgage to purchase another real estate investment property for your IRA.

Finally, it is important to note that when you become 70.5 years old, you are required to begin taking minimum distributions. Since it is hard to sell real estate holdings in small portions, you must ensure that you have enough cash in your IRA accounts to cover these required distributions. If you do not have enough cash, or cannot sell your real estate holdings n small portions, then you may encounter tax issues.

5 Steps to Get Started with an SDIRA

5 Steps To Get Started with an SDIRA

Starting down the road to a self-directed IRA real estate investment is made easier when you follow these five steps:

Step 1: Identify a potential investment and complete the necessary due diligence.

It is important that you consult with your accountant or financial advisor before you make any investment decisions. These individuals will help make sure that you have “done your homework” by performing a thorough due diligence on all alternative assets, including investment real estate properties.

Step 2: Request the funds and direct your investment.

Before you can initiate an investment, you will need to complete a Direction of Investment (DOI) form. This form contains details about the investment, such as: how much to invest, where to send the funds, and what documents need to be signed. Remember, as part of the earlier definition for a SDIRA, “the account owner directs the account trustee to make a broader range of investments.”

Step 3: The investment is processed.

Your account trustee will ensure that your chosen investment is processed per the instructions detailed in the DOI. Once the purchase is completed and the closing finalized, your IRA will be the title owner of the acquired asset.

Step 4: Manage your new investment within the IRA.

Remember that all expenses related to your IRA-owned investment must be paid from the IRA. Additionally, all income or profits that are generated must be directly returned to the IRA. The latter sequence of events can provide a tax advantage in the form of “tax deferment.”

Step 5: Plan your next steps and have an exit strategy.

The direction and lifecycle of your SDIRA is in your hands. That means that if you plan on selling or leasing an asset, it is up to you; however, your appointed account trustee will process the sale or lease, based on your instructions. In the event of a sale, the asset will be removed from your SDIRA and replaced with the proceeds that the sale generated.

It is important to note that before you complete any of the above five steps, you should first consult with a financial professional, accountant, and/or tax attorney.

The Incredible Importance of CPAs

The purpose of this article is to help you understand how you can use your self-directed IRA to invest in real estate. Whether you want to defer taxes, increase your income, or diversify your retirement nest egg, there are many benefits that can be enjoyed when you leverage the potential of a SDIRA. However, it is important that you don’t let the name of the account fool you.

While a SDIRA does put the control of your financial future back into your hands, it can be incredibly helpful for you to find and work with a good CPA who understands real estate investing, knows the law, and can help save you money while simultaneously minimizing taxes. The right tax advice can make all of the difference in helping you have the desired level of wealth when it is time for you to retire.

Key Takeaway Points for Using Self-Directed IRA to Purchase Investment Property

After reading this article, you might be ready to start your journey towards a SDIRA account. But, before you go, here are a few key takeaway points that you should hold onto: SDIRAs are a great way to enjoy numerous tax benefits, while simultaneously gaining the freedom needed to invest in alternative assets.

A SDIRA can be quite complicated, especially when it comes to the taxes, which is why it is critically important to work with a trusted CPA. The rules and regulations of a SDIRA must be carefully followed so that a taxable event doesn’t occur. The risks associated with a SDIRA can best be avoided through a mindful approach to investment. The benefits of a SDIRA include the ability to increase the potential for growth, taking control of your financial future, and enhancing your ability to protect against economic fluctuations.

Keep in mind that tax laws can change in the blink of an eye, which is why it is always a great idea to check with your trusted CPA that everything you learned in this article is still applicable. If a self-directed IRA is the right retirement account for you, then you should work with your financial advisors to begin the journey towards a diversified portfolio that can result in cost savings, tax benefits, and increased wealth.

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(1) Beginner’s Guide: Purchasing a Rental Property with a Self-Directed IRA – The Entrust Group
(2) How to Invest in Real Estate With a Self-Directed IRA – The Balance
(3) What is a Required Minimum Distribution (RMD)? – The Balance
(4) UBIT (Unrelated Business Income Tax) – Equity Trust
(5) Retire Rich With Rentals by Kathy Fettke

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