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Buying Rental Properties With a Self-Directed IRA

To invest in rental properties with your retirement nest egg, you need to set up a Self-Directed IRA (SDIRA) through an IRS-approved custodian.


[Updated: Feb 04, 2021] Jan 30, 2020 by Ruth Lyons
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Every investor knows you can buy stocks, bonds, and mutual funds with an IRA. But tell your financial advisor you want to buy a rental property and you’ll likely hear, "You can’t do that." The truth is you can do it; a traditional financial institution just can’t do it for you.

The IRS allows you to invest your qualified retirement funds in real estate, private equity, precious metals, and a wide variety of "alternative" investments as detailed in IRS Publication 590 and Internal Revenue Code 4975. As long as the IRS rules governing retirement plans are followed, your IRA can own income-generating real estate, such as commercial and residential rental properties. There are also several other alternative investments you can own in a SDIRA.

To invest in rental properties, you just need to set up a Self-Directed IRA (SDIRA), which is a special type of traditional or Roth IRA trust account that offers a wider array of investing options, including rental real estate.

SDIRA puts you in control of your investing decisions

The "self-directed" part of the name stands for just that: You direct the dispersion of the funds in your SDIRA through a qualified, IRS-approved trustee (called a custodian) who holds your funds and completes investing transactions based on your instructions. An IRA custodian is a bank, credit union, or financial entity that is responsible for record-keeping and IRS reporting requirements. Custodians do not give tax or legal advice or make any investment recommendations for you.

Obviously, this type of IRA places a lot of responsibility on you, the account holder. Unlike a traditional IRA where you’re given a menu of investments to choose from, you must find your own rental properties and do proper due diligence. So, it’s important that you become well versed with the ins and outs, advantages and disadvantages, and features and benefits to make sure you want to transfer your funds to an SDIRA and take on the responsibility to self-manage your retirement assets.

Ignore the rules at your peril

To maintain status as a qualified retirement account, there are a lot of rules you need to follow which generally fall under three categories:

  1. You must use an IRS-approved custodian trustee to set up and manage your account.
  2. You cannot transact any investments with "disqualified persons" such as yourself, certain family members, and key persons in a company-owned business.
  3. You cannot engage in "prohibited transactions" as defined in IRS Publication 590 and IRC 4975(c)(1). A prohibited transaction involves a transfer of plan income or assets to, or use of them by or for the benefit of, a disqualified person, including yourself.

The rules are intended to maintain the integrity of the IRA designation and separation of the funds as retirement assets. You and the money in your SDIRA must be completely separate entities. That means expenses to maintain the rental properties, such as property taxes and maintenance, held in your SDIRA and all rental income are transacted through your SDIRA custodian, not you personally.

You can only direct and manage the process at arm’s length. You can’t use qualified retirement funds to purchase or hold investments that benefit you personally.

A few examples of prohibited actions

  • You can’t transfer property you already own into your SDIRA.
  • When you buy an investment property with your SDIRA, you personally cannot do any of the maintenance or rehab work yourself. While you make the decision about what needs to be done and who does it, neither you, nor any other prohibited individual, can personally do or pay for any of the work.
  • You cannot purchase a property and rent it out to a relative.
  • All transactions and contracts -- whether hiring a handyman to repair a toilet or securing an alarm system with a monthly contract -- are conducted in the name of your IRA, never your personal name nor secured with your personal credit.
  • You cannot be the real estate broker and receive a commission when your IRA purchases property.
  • You must pay and receive fair market value when conducting investment transactions.

The consequence of breaking the rules is disqualification of the entire retirement account as of January 1 of the year the disqualifying transaction occurred. In other words, your entire account (not just the asset on which you broke the rules) is deemed "not qualified," and is distributed to you as taxable income. You may also incur hefty penalties (including a possible 20% "accuracy-related" penalty fine) in addition to paying distribution taxes and an early withdrawal penalty.

Pros of buying rental properties through your SDIRA

  • Tax-deferred rental income and asset appreciation. As is the case with any IRA investment, you benefit from tax-deferred income until the day you make a withdrawal. Whereas you’ll pay taxes on real estate gains outside your IRA, you can buy and sell properties and move funds from one project to another while maintaining the tax-deferral status of your gains and market appreciation.

One of the things real estate investors love is the ability to depreciate properties for annual tax breaks. Owning real estate in an IRA allows your investment to grow on a tax-deferred basis (or tax-free basis if you’re using a Roth), so there’s no need to claim depreciation on IRA-owned real estate.

  • Ability to invest in what you know. This is the biggest benefit for real estate investors. I am an example of this I know real estate and have been successful investing in it. I love the opportunity to invest in what I know and have the control to grow my IRA faster with real estate than trying to do so in assets I’m not as familiar with.
  • Investment portfolio diversification. Rental real estate is not directly correlated to the stock market, and holding a portion of your IRA in rental real estate can be an excellent way to diversify your IRA holdings to reduce overall portfolio risk.
  • Rental property accounting made easy. Everything is done within the IRA, so there’s no need to track rental income or expenses separately, and there’s no need to file tax returns annually.
  • High return on investment potential. Rental real estate investing can be a very lucrative investing choice.
  • Leverage. Leverage grows wealth quickly when investing in real estate. And your SDIRA allows you to borrow money to purchase more rental properties. You can leverage your SDIRA holdings with a nonrecourse loan.

Cons of buying rental properties through your SDIRA

  • Not a good choice for novice investors. You can make some costly mistakes if you don’t have a fairly good understanding and comfort level with rental property investing. This is your retirement nest egg, not play money. Investing in real estate isn’t rocket science, but it takes time and effort to learn to do it successfully.
  • Harder to achieve real estate diversification. Investment properties are expensive. Since you’re buying a hard asset (that can’t be moved to a different location if the neighborhood turns bad), you need a lot of money to buy enough properties in diverse locations to achieve diversification.
  • Harder to liquidate assets. As with any IRA, you are required to take minimum distributions once you reach age 70½. If you own rental properties in an IRA, you can’t sell off small chunks each year. You’ll need to plan to liquidate your properties into cash as needed to take minimum distributions, or you’ll run into tax problems.
  • Disqualification is possible. If you don’t follow the rules, your IRA status could be disqualified, creating a huge taxable event.

Make the decision that’s right for you

The freedom to buy and own rental properties with IRA-qualified funds is very appealing to many investors, including me. It gives me the opportunity to invest in what I know, reduce my investing risk, and substantially increase my gains over what I was previously able to achieve through stock investing.

It takes time and effort to set up the account and manage the activities. You must do your due diligence on the custodian you choose and conduct extensive research and analysis on all the investment opportunities you consider. You are in charge of all decisions -- your custodian acts as a trustee carrying out your investment decisions on behalf of your account. Rental real estate investing isn’t for the passive investor, whether you’re investing directly or with your SDIRA.

Engaging in prohibited transactions and/or with disqualified persons are serious infractions, and the penalties for negligence are severe. Don’t take chances with your future. Be sure to know, respect, and follow the rules.

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Take the first step towards building real wealth by signing up for our comprehensive guide to real estate investing.

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