What is a Self-Directed IRA?
An Individual Retirement Account (IRA) is a type of savings account that is designed to help you create a healthy nest egg for your retirement while offering multiple tax benefits. However, regular IRAs limit your investments to more traditional asset options such as mutual funds, stocks, and bonds. Whereas a self-directed IRA allows you to go beyond that and broaden your portfolio by investing in other avenues such as real estate, private equity, franchises, etc. instead of letting the Internal Revenue Service limit your investment decisions. Self-directed IRAs are also known as participant-directed IRAs.
Since self-directed IRAs allow you to diversify your portfolio, a growing number of retirement savers are now choosing to invest in real estate to increase their overall returns. But real estate investments done through self-directed IRAs come with its own set of rules and regulations.
Starting a Participant-Directed IRA
In order to invest using a self-directed IRA, the IRA must be held by a qualified trustee or custodian, who can provide administrative services such as maintenance of records, issuing client statements and providing information pertaining to government rules and regulations. Another point to note is that a self-directed IRA also requires you to accurately value your investment annually and report the value to your IRA custodian.
Once you have your IRA set-up all figured out, take note of the dos and don’ts of using your self-directed IRA to invest in real estate.
- You can purchase land or property with your IRA as long as it wasn’t previously owned by you or your family members (this includes your spouse, parents and your children). You are also prohibited from selling any property to your spouse, family or any other relative. This rule also extends over the leasing of property to family members as they are considered disqualified persons under the IRA laws.
- While purchasing a property through your IRA, all property related expenses must be paid using your IRA and thus you must ensure you have sufficient cash in the account. This is because using external capital to fund the management expenses can lead to the loss of tax benefits or penalties.
- When renting out your IRA property, tenants must address their rent checks directly to the IRA and not you, personally. This is imperative as accepting rent checks personally could trigger penalties as it is considered to be a prohibited transaction in case of self-directed IRAs.
- You are not allowed to use any property bought using your IRA as a family/vacation home as all properties owned through your self-directed IRA as designed to bring you benefits only upon retirement and not earlier than that.
Recommended IRA Posts:
Now that you know the rules involved in real estate investments, take a look at the benefits as well as the disadvantages of making such investments through your self-directed IRA:
Benefits of Investing in Real Estate through Your Self-Directed IRA
Potential Tax Benefits of Participant-Directed IRA or Self-Directed IRA
While traditional IRAs investments can only prove to be beneficial until the day your take withdrawals or reach your retirement age, real estate IRA investments allow you to buy, sell or flip properties and move funds from one project to another while maintaining the tax deferral status of the IRA.
Stable Real Estate Market
In a world of mutual funds, bonds and stocks, where the markets keep changing, real estate is a relatively stable sector that allows you to pick a property of your preference after due diligence. There have been real estate market crashes in the past, but over the long term, the market has proven to be relatively stable.
Downsides of Investing in Real Estate using Your Self-Directed IRA
Lack of Portfolio Diversification
One of the biggest downside of investing in real-estate is the lack of portfolio diversification. This is because real estate investments require large sums of cash, which can take up most of your savings, leaving little space for any other type of investment.
Lack of Liquidity
Since returns on real estate investments are calculated on the basis of land appreciation over the years, you may not have cash in hand even though your investment has doubled or tripled as it will be considered as an asset.
So, if you are planning to make a real-estate investment using your self-directed IRA, be sure to hire an experienced IRA custodian who can guide you through the investment process and who has a good grasp over the rules and regulations. They should be able to guide you and tell you which property is best after gauging your savings and help you diversify your portfolio so that you can enjoy your retirement years!
Author Bio: Rick Pendykoski is the owner of Self Directed Retirement Plans LLC, a retirement planning company based in Goodyear, AZ. He has over three decades of experience working with investments and retirement planning, and over the last ten years has turned his focus to self-directed ira accounts and alternative investments.