Rules of Buying Real Estate in An IRA

A self-directed investment retirement account (SDIRA) is a great way for you to take control of and diversify your retirement investments. It’s a path that will demand more of you since you’ll be more involved in managing your investment, which comes with its own setbacks and rewards. But for those who are willing and able to put in the time and effort, an SDIRA can be of great benefit.

Rules of Buying Real Estate in An IRA

What is a Self-Directed IRA?

An SDIRA is a retirement investment account that allows you to invest in “alternative investments”. When you own a SDIRA you have to follow the rules to the letter or else you’ll disqualify your account, which means you’ll have to pay taxes on all your money! So, no self-dealing, which means no buying from or selling to someone you know; you can’t be the one doing the repairs; and no personal benefits, like keeping your car in the garage or letting a friend live in your finished basement.

It’s important to remember that you and your IRA are not one and the same. As a result, your investments need to be titled to your iRA and not to you. Those are the rules, so make sure to follow them. Otherwise you’ll encounter delays or experience significant penalties.

The Right IRA for Buying Investment Property

To make real estate investments using your SDIRA you’ll need to work with a company that won’t be making your decisions for you. All the decisions are on you! You’re going to need a custodian, who will be the one to execute your decisions. The custodian’s main job is to make sure you don’t violate any of the many rules governing your SDIRA!

What Properties are Eligible?

Every type of property is eligible for your SDIRA, so long as it’s sold by the right type of person!

What Is and Isn’t Yours

As you can tell, your property is only meant to be an investment. That means it can’t benefit you or what the IRS calls a “disqualified” person in any way. That means your spouse, relatives, a co-investor who owns more than 50% of the property, or anyone servicing your IRA.

Making the Purchase

If you’re going to make a purchase, you’re going to need a proof of funds (POF) letter. This letter demonstrates that you have cash to invest as well as a commitment to do so. Agents prefer POF letters dated within the last 30 days, so you’re likely to need more than one POF letter during your investment career.

You’re going to want to work with a real estate agent that meets several criteria. Someone who’s full time, a licensed appraiser, and an agent. The advantage of having an agent who’s also an appraiser is that they’ll be able to identify problems with your property! You’ll also want someone who works for a company with a good reputation, so do your research! Lastly, you’ll want an agent capable of making lowball offers to get you the best price for your investment!

You’re likely going to have to do repairs on your property, but you cannot do any of the repairs yourself. Those are just the rules of an SDIRA! Similarly, the rules of an SDIRA stipulate that it’s the account custodian who’ll end up paying for all the expenses. So you sign a “direction of investment” form, and the custodian takes care of the payment.

Owning the Property

If you bought a property that’s never been rented before, you’re going to need a county inspection and a rental license first. You may also want to hire a property management company to take care of all the work, like putting together a rental lease and finding tenants, so that you have minimal work to do. The property management company will also collect the rent and send it to your SDIRA custodian, since, again, all the money has to be handled by the custodian of the IRA.

Selling a Property in an IRA

Just like other aspects of your SDIRA, you’ll be in charge of negotiating the conditions of your sale but the custodian will be the one to handle the transactions. One of the things to keep in mind about real estate is that it usually has low liquidity, meaning that it’s hard to convert your investment to cash quickly.

Rules of Buying Real Estate in An IRA

Pros and Cons of Property in an IRA

A rental property, unlike a stock, is something you can physically inspect! Investing in alternative assets allows you to build a diverse portfolio, which will help you become a more resilient investor. Lastly, if you think you can do a good job of managing your investments, or at least want to be the one making the decisions, then an SDIRA is for you.

It’s also in your best interest to open a Roth IRA rather than a regular IRA. A Roth IRA entails paying taxes on all your deposits, which will include any income you generate from your investments. But the benefit is that you make your withdrawals tax-free. Since you’re likely to make more money from your investments as time goes on, it behooves you to pay your taxes sooner rather than later because you’ll be paying a lower rate when you’re first starting out since you’ll be making less money at first.

Working with a custodian may appear like a con of having an SDIRA because it’s one more step between you and you investment, but your custodian is working in your best interest, so they’re actually a pro! All expenses have to be paid with your SDIRA funds, so always make sure you have enough money in your account to pay your bills.

What are the Tax Benefits (or Pitfalls)?

A big plus of using an SDIRA to invest in real estate is tax-free growth. If you make a profit of $200,000, tat amount would be tax-deferred, meaning that you wouldn’t pay taxes until you make your withdrawal. But if you made that profit outside of an SDIRA, you’d have to pay federal income tax as well as, most likely, state income tax too. Next, if you use an SDIRA to invest in alternative assets, then you can invest is in tangible goods that you’ll be able to see for yourself.

Having a SDIRA, however, makes getting a loan tricky because the loa has to be a non-recourse loan, which is a loan that’s not guaranteed by the SDIRA holder. Otherwise, you might have to pay a tax rate as high as 37%, because you’ve triggered the unrelated business taxable income (UBTI) rules. You also won’t be able to make use of depreciation and interest write-offs.

Who Should Buy Real Estate in Their IRA

Using your SDIRA is a great option for someone who already knows what they’re doing. If you’re an experienced real estate investor, someone who knows how to buy and sell raw land, a property flipper, or someone holding several rental properties, for example, then you could make good use of the tax benefits of an SDIRA. Hopefully you’re also someone who can afford to not withdraw their funds until the age of 59 ½ !

Finding a Custodian for Real Estate IRAs

SDIRAs are managed by custodians who make transactions on your behalf. In order to make alternative investments you’ll need a custodian that offers alternative investments.
The custodian’s responsibilities will include bookkeeping, and reporting all your deposits, withdrawals, and year-end balances to the IRS. Your custodian may tell you where to find all the information you’re going to need to manage your SDIRA, but they’re unlikely to provide you with tax or legal advice. That’s on you!

Bottom Line

The biggest pro of an SDIRA is also its biggest con: the success of your investment depends entirely on you! Luckily, investing in real estate is something you can master if you have the time and inclination to do so. You don’t even need that much money to start if you know of creative financing avenues! Of course, you can add the diversity of investing in real estate to a regular IRA by investing in an REIT (Real Estate Investment Trust), which is a portfolio of real estate investments that’s traded on private and public exchanges just like a stock. But if you have stomach for it and can absorb the potential losses, than investing in real estate using an SDIRA might be fore you!

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