An Individual Retirement Account, most retirement accounts are made up of various investments, such as equities, bonds, mutual funds, ETFs, and CDs (IRA). However, an increasing number of retirees are opting for less-common assets.
Self-directed IRAs (SD-IRAs) allow you to invest in various assets, including real estate, precious metals, notes, tax lien certificates, private placements, and more.
However, these aren't always the ideal investments for your retirement. When buying real estate with an IRA, there are a few factors to remember.
What Is a Self-Directed IRA?
A self-directed IRA is a traditional or Roth IRA in which the custodian allows you to invest in various ways. Real estate investments are one of these alternatives.
Many people who desire to use a self-directed IRA to buy rental properties are interested in real estate investing.
The financial institution in charge of record-keeping and IRS reporting is an IRA custodian. You must appropriately assess your investment and submit the value to your IRA custodian each year if you have a self-directed IRA.
Buying Real Estate With a Self-Directed IRA
You must first open an account to use a self-directed IRA to acquire real estate. Many companies allow you to open your own SD-IRA; however, these accounts can be complicated. Having a custodian who can assist you while you navigate the IRS tax code can be beneficial.
Because real estate investments impose a greater cost on the custodian, many IRA custodians do not offer it as an investment choice. The Internal Revenue Service (IRS) does, however, allow plans to include real estate as an IRA investment option.
Some IRA custodians charge more complicated fees than others. You'll need to do your homework and look at all the fees and charges affecting your total return.
You may need to form a limited liability business (LLC) to hold your SD-IRA assets. A custodian or tax expert can assist you in determining if this is the best option for you.
It would help if you generated enough cash flow with self-directed IRAs to meet all future home renovation and repair needs without adding funds each year.
What Are the Benefits of Owning Real Estate in an IRA?
Buying real estate with a self-directed IRA could result in tax advantages. The income that goes into your IRA is not taxed until you withdraw, just like any other asset in your IRA. If you have a Roth IRA, your income is taxed as usual. Your investment earnings will grow tax-free, and you can withdraw them tax-free.
It would help if you still waited until you were 59 1/2 years old to withdraw your funds. On your tax return, that withdrawal will be treated as ordinary income. You may face a penalty if you remove them too soon.
If you're a real estate investor, you can purchase, sell, or flip property without losing your SD-tax-deferred IRA status. You can also transfer funds between projects.
The familiarity factor is a second reason to own real estate in an IRA. Many investors like local real estate, and you may prefer to continue with it during economic turmoil. SD-IRAs allow you to invest in assets you are familiar with and trust.
What Are the Potential Downsides and Risks?
You are responsible for keeping up to date on the property if you have a self-directed IRA. This may appeal to you if you've ever worked as a real estate investor or flipper. It can easily lead to poor or unsafe decisions if you aren't a skilled real estate investor. In the event of fraud, you may be a more vulnerable target than more seasoned investors.
An investor advisory from the Securities and Exchange Commission (SEC) addresses self-directed IRAs and the risk of fraud.
One of the most significant risks is the lack of diversification that comes with owning real estate in an SD-IRA. You can't build a broad real estate investment portfolio if you don't have enough money to buy various properties.
Another major problem with holding real estate in an IRA is liquidity. When your money is locked up in real estate, it might be challenging to get it out. If you need money soon, this could prohibit you from receiving payouts.
What Are SD-IRA Tax Pitfalls to Avoid?
When you invest in real estate through an IRA, you can defer paying taxes on your earnings. Roth IRAs offer the possibility of tax-free growth, but if you don't follow the requirements, you could buy the incorrect property. This could render the IRA ineligible and result in a taxable event.
If you own real estate in your IRA, you won't be able to take advantage of some of the tax incentives available to most real estate investors if the property is losing money. Depreciation cannot be claimed on IRA-owned real estate.
Think twice about using your IRA to buy a second property or a primary residence. All the real estate purchases with your SD-IRA must be made at arm's length.
That means no self-dealing or personal transactions are permitted. Your immediate family is included in this rule. It will no longer be tax-free or tax-deferred if you buy or sell a property to a family member (or yourself).
Another tax difficulty you can face is unrelated business income tax (UBIT). If you're considering buying a house with a mortgage, you should be aware of this tax.
When you reach the age of 70 1/2, you must take the required minimum distributions (RMDs) from your conventional IRA. However, if your 70th birthday falls on or after July 1, 2019, you will not be required to take withdrawals until you reach the age of 72, according to amendments enacted by the SECURE Act.
However, selling off your real estate holdings in little portions each year is challenging if you own real estate in an IRA. As a result, you must maintain sufficient funds in your IRA accounts to cover your RMDs. You may face tax issues if you do not have the required funds.
Frequently Asked Questions (FAQs)
When it comes to IRA-owned real estate, how do mortgage tax advantages work?
When you buy real estate using an IRA, any mortgage tax advantages you ordinarily qualify for are forfeited. Because IRAs are already tax shelter accounts, you won't be able to take advantage of any other tax benefits if you utilize one. You shouldn't use your IRA for the transaction if you want to maximize your tax benefits.
What companies can assist you in using your IRA to purchase real estate?
Some businesses may be more willing to assist you in setting up an SD-IRA than others. If you have an IRA with a brokerage like Fidelity or TD Ameritrade, the brokerage would likely prefer you invest in real estate through mutual funds, ETFs, or equities. Companies that provide SD-IRAs for real estate investments are likely to specialize in that service; thus, their marketing materials will be highlighted prominently. While performing your research, if a company doesn't mainly discuss SD-IRAs and real estate investments, you should look for another SD-IRA provider.