Personal retirement funds, like those held in self-directed IRAs, are an often-overlooked source of capital for investing in real estate because most investors don’t know it’s possible to invest IRA funds beyond stocks, bonds and mutual funds. This type of investing has been legal since the Employee Retirement Income Security Act (ERISA) was created in 1974.
But self-directed IRAs give account owners control over choosing their investments and they can use IRA funds to participate in almost any form of real estate investment – from condominiums and office complexes to real estate investment trusts (REITs) or single family residences.
Using an IRA to invest in real estate enables investing with tax-advantaged dollars. When a real estate investor uses retirement dollars, capital gains are generally avoided and taxes on income from return on investment are deferred until it’s time to take distributions.
If the investor uses a Roth IRA, account holders can typically avoid paying taxes on distributions or profit generated by the sale of the property entirely. It always a good idea to review the investment with a qualified tax professional.
To give you more insight into SDIRAs, we conducted a brief Q&A session with Christopher Orr, Director of Institutional Products at PENSCO Trust Company. Founded in 1989, PENSCO Trust Company is a regulated, self-directed IRA custodian with more than $10 billion in assets under custody and 45,000 clients.
1. What are some of the differences between purchasing and maintaining real estate in an IRA versus a traditional property investment?
There are four big differences:
- The property’s buyer is the IRA, not the investor. That’s why paperwork must flow through an IRA custodian like PENSCO.
- All expenses and revenue must go through the IRA. Expenses must be paid by the IRA and any revenue must remain in the IRA.
- You can’t use the property for personal reasons. The property must be treated as an investment, not for the immediate benefit of you, your business or your family.
- Maintenance and repairs must be done by a third party. If the IRA owner provides any sweat-equity activities – even something as minor as changing a light bulb — they could incur significant penalties.
2. Can you describe some of the common ways to invest in real estate with a self-directed IRA?
Here are some of the most common ways to invest in real estate with a self-direct IRA:
- Direct purchaseThe IRA buys the entire property outright using funds in the account. The income and expenses flow directly in and out of the IRA.
- Partnerships or tenants-in-common (TIC) purchaseThese transactions combine the investor’s IRA funds with other investors’ funds or in conjunction with the IRA owner’s non-IRA funds. The investment income and expenses are handled proportionate to each entity’s ownership amount.
- Mortgage-backed purchaseIn these purchases, the IRA borrows money to purchase property. Important caveats to note are that neither the IRA, nor the account owner, can have any personal liability in the mortgage (investors cannot back their own loans). A non-recourse loan must be used so that the lender can only seize the actual property being purchased and not the rest of the IRA’s assets if the borrower defaults on the loan. All mortgage payments are made with IRA funds. In addition, if property purchased in an IRA is financed by debt, income produced by that property, as well as gain on sale, could be subject to tax. It’s always best to consult with a tax professional in these situations.
- Limited liability corporationIn these transactions the property title is held in the name of the LLC. In this case, the IRA holds an interest in the LLC rather than title to the property.
The process of purchasing a property directly in one’s IRA account is similar to the process of purchasing it outside of an IRA. The main difference is that all documents – after being initialed/signed by the account owner – must be countersigned by the IRA custodian, and the money for the purchase must come directly from the IRA as well. Investing in real estate using a self-directed IRA does require more legwork and maintenance by the underlying client to avoid any prohibited transactions; however, it gives the client more freedom and control than other types of real estate investments.