What is a Self-Directed Individual Retirement Account?
A self-directed individual retirement account is a traditional retirement account or a Roth IRA that allows the account holder a wide range of investment options. One of these options is real estate investments.
Buying Real Estate Using a Self-Directed Individual Retirement Account
To buy real estate using a self-directed individual retirement account, you first need to set up an account. Many companies allow you to set up a self-directed retirement account, but these accounts can be complex. It is helpful to have a custodian who can provide guidance while navigating the IRS tax laws.
Since real estate investments are more burdensome for the custodian, many of them do not offer real estate as an investment option for self-directed IRAs. However, the IRS does allow the inclusion of real estate as an investment option in self-directed individual retirement accounts.
Some self-directed IRA custodians have more complex fee structures than others. You will need to do your research and review all fees and expenses that will affect your total return on investment.
You may need to establish a limited liability company (LLC) to hold the assets of the self-directed IRA. The custodian or tax advisor can assist you in determining if this is the right choice for you.
With self-directed IRAs, there should be sufficient cash flow to cover all home improvement and repair costs without having to add cash each year.
Benefits of Owning Real Estate in a Self-Directed Individual Retirement Account
Using a self-directed individual retirement account to purchase real estate comes with the opportunity to benefit from tax advantages. As with any investment in your individual retirement account, the income that enters your account is not taxable until you withdraw it. If you have a Roth IRA, you will pay taxes on your income as usual. Then, your investment earnings will grow tax-free and can be withdrawn tax-free as well.
Note: You still have to wait until you are 59 and a half to withdraw your funds. If you take them out early, you may be subject to a penalty. This withdrawal will be included as ordinary income on your tax return.
If you are an active investor, you can buy and sell or flip real estate without losing the tax-advantaged status of your self-directed IRA. You can also transfer funds from one project to another.
Another reason to own real estate in a self-directed IRA is familiarity. Local real estates are attractive to many investors, and you may prefer to stay invested in them during times of economic uncertainty. Self-directed IRAs allow you to place your money in assets that you know and trust as well.
What Are the Risks and Potential Pitfalls?
When you own a self-directed individual retirement account, you are responsible for monitoring the property itself. You may appreciate this if you have prior experience as a real estate investor or flipper. However, if you are not a savvy real estate investor, it can easily lead to unwise or risky decisions. In cases of fraud, you may be a target more than experienced investors.
Warning: The Securities and Exchange Commission (SEC) has a warning for investors that addresses self-directed individual retirement accounts and the risk of fraud.
One of the biggest risks of owning real estate in a self-directed individual retirement account is lack of diversification. If you don’t have enough cash to hold a variety of properties, you will not be able to build a diversified real estate investment portfolio.
Liquidity is another significant issue when owning real estate in a self-directed individual retirement account. When your cash is tied up in real estate, it can be difficult to access. This may prevent you from taking distributions if you need money quickly.
What
What are the tax risks of self-directed individual retirement accounts?
Owning real estate in a self-directed IRA allows you to defer paying taxes on the income you invest. Self-directed Roth IRAs offer the potential for tax-free growth, but if you don’t follow the rules, you may purchase the property in the wrong way. This could result in the disqualification of the self-directed IRA and create a taxable event.
Owning real estate in a self-directed IRA also means you lose some tax breaks that most real estate investors can benefit from if the property operates at a loss. Additionally, you cannot claim depreciation on properties you own in a self-directed IRA.
If you plan to use a self-directed IRA to buy a second home or primary residence, think again. All properties you purchase with a self-directed IRA must be sales and purchases between independent parties. This means you cannot engage in any personal or related transactions yourself. The rule also applies to your immediate family members. If you buy or sell property to a family member (or to yourself), it will no longer be tax-exempt or tax-deferred.
Unrelated Business Income Tax (UBIT) is another tax issue you may encounter. You will need to be aware of this tax if you are considering using a loan to purchase property.
With a traditional retirement account, you must take required minimum distributions (RMDs) once you reach age 70 and a half. However, due to changes introduced by the SECURE Act, if your 70th birthday is July 1, 2019, or later, you do not have to take distributions until you reach age 72. But if you own property in a self-directed IRA, it can be difficult to sell your property interests in small parts each year. For this reason, you should keep enough cash in your self-directed IRAs to cover your RMDs. If you don’t have the cash you need, you may face tax issues.
Frequently Asked Questions (FAQs)
How do mortgage-related tax benefits work with properties you own in a self-directed IRA?
Any mortgage-related tax benefits you may typically qualify for will be lost when purchasing properties through a self-directed IRA. Individual retirement accounts are already tax shelter accounts, so you will lose any additional tax benefits when you choose to use a self-directed IRA.
Which companies help you use a self-directed IRA to buy real estate?
Some companies may be more willing than others to help you set up a self-directed IRA. If you have a retirement account with a broker like Fidelity or TD Ameritrade, for instance, the broker is likely to prefer using mutual funds, exchange-traded funds, or stocks to invest in real estate. Companies that offer self-directed IRAs for real estate investing often specialize in this service, so they will make it a prominent part of their promotional materials. If the company does not specifically mention self-directed IRAs and real estate investments during your search, you may need to find another company for your self-directed IRA.
Source: https://www.thebalancemoney.com/how-to-invest-in-real-estate-with-a-self-directed-ira-4057066
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