Protect Your Retirement With Self-Directed Real Estate IRAs

Real estate investment by individuals is on the rise, but for the most part it has been confined to real estate investment trusts (REITs) and real estate mutual funds. However, the emergence of self-directed IRAs, which not only enable but encourage real estate products, is beginning to change the situation. Direct investment in real estate is becoming a growing option for retirement-oriented investors who want to take advantage of the return potential of real estate and its capabilities as a portfolio diversifier and inflation hedge.

Self-directed IRAs allow investors the same discretion they normally have over their taxable investments, but allow for tax-deferred earnings growth. In the form of a self-directed IRA, investors can invest directly in real estate, mortgages, private placements and other non-traditional assets: Section 408 of the Internal Revenue Code allows the purchase of property with funds held in many common forms of IRA, including a Traditional IRA, a Roth IRA, and a Simplified Employee Pension (SEP) IRA. With such structures, investors can achieve significant flexibility in investment options, greater control over their retirement assets, and the investment potential provided by direct real estate investments.

Key takeaways

  • Self-directed IRAs allow for tax-deferred earnings growth.
  • Self-directed IRA accounts are also managed by the account owner rather than a financial institution.
  • Investment options for self-directed IRAs are not limited to traditional assets.

Self-directed IRA

A self-directed IRA is one that allows the account owner to actively manage the portfolio, make investment decisions, and choose products, from stocks and bonds to alternative investments, rather than being done by a financial institution.

To invest using a self-directed IRA, the IRA must be in the hands of a qualified trustee or custodian. Typically, these trustees provide administrative services, such as keeping records of contributions and other activities, filing required IRS reports, issuing client returns, and providing information related to the rules and regulations governing IRAs (for example, contribution limits and deductibility rules, rules for distributions, and penalties for early withdrawals).

Investment options for self-directed IRA accounts

Investment options for self-directed IRAs are not typically limited to traditional assets, but include everything allowed by the IRS. This creates greater potential for diversification than regular IRAs, where investments are often limited to mutual funds or certificates of deposit (CDs). However, while all types of investment are allowed by federal regulations, not all custodians provide all asset classes, including real estate or mortgages. Therefore, prospective account holders should consult with the custodian before establishing the IRA.

Investments not allowed

These IRAs cannot invest in assets prohibited by the IRS, such as life insurance and collectibles, and must follow the same IRS rules and regulations that regular IRAs cover.

Although the IRA is a nondiscretionary account, the regulations make the owner of the IRA responsible for meeting all regulatory requirements. Since the custodian generally does not determine whether the investment meets regulatory requirements or provides legal / tax advice, investors interested in self-directed IRAs should seek the advice of an independent tax or legal advisor.

Investment options

Beyond stocks and bonds, the investment options available for self-directed IRAs can include the following types of real estate vehicles:

Finding a custodian who is experienced in handling these investments is important as special tax filing rules and operating procedures apply.

Ban on auto-trade

You can buy land or property (residential and commercial) in your IRA as long as it does not result in self-negotiation. This means that you cannot buy a house or building in which you will reside or do business. Your IRA also cannot buy any property that you own or a business in which you or certain members of your family have a specific percentage of ownership. The IRA is also prohibited from selling any property to you or to any of the parties listed above.

Operating procedures and taxes

Once you have provided the proper documentation and instructions to purchase the property, your IRA custodian will initiate the purchase of your IRA. The title to the property will reflect the name of your IRA custodian. All property management and property-specific expenses must be made through the IRA, so the IRA must have enough cash to pay these amounts. Having to rely on external capital to finance management costs can lead to loss of tax benefits or the imposition of penalties.

If the property is financed with debt, it can create what is known as unrelated business taxable income (UBTI), which is taxable under IRS code. This is different from other earnings, which are tax deferred until they are withdrawn from the IRA. Investors who wish to invest in debt-financed assets should contact their tax advisor to investigate the tax implications.

Checkbook control

For investors who want more influence over their investments, checkbook control is another option. This allows the IRA owner to make purchases by writing checks on behalf of the IRA. Transactions are facilitated through an LLC that is owned by the IRA. Other legal structures, such as S corporations, are generally not available as they do not allow IRAs as investors. Creating an LLC to invest in an IRA account can give an investor even greater control over their assets and lower certain custody fees.

Generally, an IRA account owner has the option of performing certain management functions, such as advertising, collecting and depositing rent checks, and paying related bills. This puts the investor at a great advantage, especially when purchasing real estate foreclosures, which is generally an urgent proposition that requires the ability to write checks on the courthouse steps.

Retirement implications

Historically, direct real estate investing has generated significant wealth for investors who understand the risk-return trade-off of this asset class. Using self-directed IRAs gives investors the ability to invest directly in property and other real estate-related assets, while also providing the ability to defer taxes from traditional IRAs.

The bottom line

In the form of a self-directed IRA, investors can invest directly in real estate, mortgages, private placements, and other non-traditional assets.In some cases, IRA owners have checkbook access to their IRA balances. With such structures, investors can achieve significant flexibility in investment options, greater control over their retirement assets, and the investment potential provided by direct real estate investments.

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Mark Holland

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