How to Buy Real Estate With an IRA

By: , Contributor

Published on: Dec 05, 2019

You can use your retirement savings to buy property, but there’s more to the story.

Individual retirement accounts, or IRAs, are best known as smart ways to hold stocks, bonds, mutual funds, and other exchange-traded investments. However, it’s possible to hold real estate and other non-traditional retirement assets in an IRA if you know how to do it.

With that in mind, here’s an overview of how to buy real estate with an IRA, the rules you need to know, and the pros and cons of choosing this investment strategy.

Not just any IRA will do when it comes to real estate investing

If you have an IRA through a brokerage (such as TD Ameritrade, E-Trade, or Schwab), you cannot buy investment properties through your account. You’ll need a special type of IRA known as a self-directed IRA. These are offered by a number of specialized firms, and the general idea is that you direct the investments that will be held in the account.

In addition to real estate, potential investments you could hold in a self-directed IRA include precious metals, tax lien certificates, cryptocurrencies, private equity investments, and more. You cannot use a self-directed IRA to buy most collectibles, such as coins, artwork, and antiques. If you want to find out if a particular type of investment is allowed, check with an experienced tax professional.

If you open a self-directed IRA for the purpose of owning real estate, you can buy pretty much any type of property you can think of. This can mean a single- or multifamily rental property, a commercial building, or even undeveloped land.

A self-directed IRA can be either a traditional or Roth IRA, depending on what you prefer (and the nature of your existing IRA if you’re planning to roll the assets over). If you’re a small business owner or are otherwise self-employed, you might also be eligible for a self-directed SEP-IRA, SIMPLE IRA, or a self-directed solo 401(k). These three account types have higher annual contribution limits than traditional or Roth options, so if you qualify, they can be especially desirable when it comes to buying property with an IRA.


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Rules you have to follow

When it comes to using an IRA to buy real estate, there are some rules that you need to strictly follow.

One of the biggest rules you have to follow is that real estate owned in your IRA must be purely for investment purposes. You and your family members cannot use it for personal reasons ever. You can’t buy a vacation rental property and use it when it isn’t occupied, for example.

All expenses of the property must be paid through the IRA, not by you directly. For this reason, it’s advisable to only buy an investment property through a self-directed IRA if you have several months of the property’s ownership expenses in cash at a minimum. If you haven’t maximized your contributions, you can put more money into the IRA to pay ongoing property expenses, but this isn’t a good strategy to rely on.

This rule isn’t limited to just monetary expenses. For example, you can’t use furniture you currently own in an IRA-owned rental property. Similarly, any income generated by real estate held in your self-directed IRA must be paid to and returned to the IRA, not to you.

Finally, you cannot use your self-directed IRA to buy property from yourself or a family member. In other words, you can’t use money from your IRA to buy an investment property you already own as a sneaky way to get cash out of your IRA early.

Can you use a mortgage to buy a property in your IRA?

The answer here is "sort of."

You can’t personally guarantee a loan backed by real estate held in your self-directed IRA. This makes sense -- after all, the IRA is the technical "owner" of the property, not you. So you cannot obtain a mortgage to buy a property in your IRA. You have to find a lender who's willing to loan money to your IRA.

There are some lenders who specialize in loans to IRAs. You’ll need to obtain a non-recourse loan, which means the lender cannot go after any assets (aside from the property itself) if you stop making your payments.

Obviously, this represents considerably more risk to a lender than a traditional mortgage. That’s why a non-recourse loan typically has a higher down payment requirement than a standard investment property mortgage (think 40% to 50% at a minimum). You can also expect a higher interest rate than you could get with a personally guaranteed mortgage.

Using leverage to finance properties in an IRA can amplify your return potential, but it also adds a considerable amount of risk. Remember that all of your expenses must be paid out of the IRA, and if your property sits vacant, you still need to make those mortgage payments.

There are also tax implications when you use leverage. While IRAs are generally tax-deferred, there’s a tax concept known as unrelated business taxable income, or UBTI, that might apply to some of your investment income if your IRA makes a debt-financed purchase like this. This creates another layer of complexity that you’ll have to deal with on an ongoing basis.

Reasons to consider real estate in your IRA

There are a few good reasons you might want to consider investing in real estate through an IRA.

For starters, real estate can generate excellent long-term returns. It’s not uncommon for a rental property to generate annualized total returns (income plus equity appreciation) of 10% or more, and that’s without using any leverage.

Second, real estate is somewhat recession-resistant. Rental occupancy tends to stay rather high even in tough economic times, and property values generally don’t fluctuate nearly as much as stock prices do. This is a very desirable characteristic in a retirement account.

In addition, real estate is already a tax-advantaged investment and benefits from things like depreciation. Owning properties through an IRA amplifies the tax advantages even more. You’ll be free to reinvest all of your rental income without paying a penny in tax, and you won’t get hit with a giant capital gains tax bill when you sell an investment property.

Potential drawbacks to be aware of

While real estate can be a great way to build wealth over time, that doesn’t mean it’s a great fit for you, especially as an IRA investment. Before you transfer your IRA assets to a self-directed IRA custodian and start shopping for a property, here are some of the things you should keep in mind:

Self-directed IRAs are generally subject to the same annual contribution limits as other traditional and Roth IRAs, which for 2019 and 2020 are $6,000 per year ($7,000 if the account owner is 50 or older). As I discussed previously, it can be difficult to get a mortgage in a self-directed IRA, so it can take a long time to build up enough cash to buy a property. In fact, most self-directed IRAs that are opened for real estate investment purposes are opened by transferring a large existing IRA balance.

If you conduct a prohibited transaction (even by accident), the IRS could consider the entire account as having been distributed to you. This can result in a hefty tax bill and large IRS penalties. It’s very important to follow the investment rules in a self-directed IRA and to consult an experienced tax professional if you have any uncertainty.

Unlike with a brokerage IRA, a self-directed IRA is all on you. The firm you open your self-directed IRA with won’t give you investment advice or any other guidance.

Many self-directed IRA investments, particularly real estate, can be rather illiquid. In other words, if you want to sell a stock in your standard IRA, you can do it with the press of a button. You may not be able to sell investment properties as quickly as you’d like in your self-directed IRA.

You typically cannot withdraw from your IRA until you’re 59 1/2 years old, unless you qualify for an early withdrawal exemption.

Once you reach 70 1/2 years old, you’re required to start taking minimum distributions (known as required minimum distributions, or RMDs) from your traditional IRA. If you have a self-directed IRA of the traditional variety and virtually all of your account consists of real estate, you might need to eventually sell a property at an undesirable time just to be able to withdraw enough money.

Is an investment property the right move in your IRA?

Owning property through an IRA can be a smart move in some situations, but it isn’t right for everyone. Weigh the pros and cons before making a decision, and if you decide to move forward, get advice from a qualified professional to ensure that your investment and the self-directed IRA itself are set up and managed properly.

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