A growing number of real estate investors are using a self-directed IRA to finance their property purchases nowadays. That’s because a self-directed IRA can provide them with the opportunity to buy real estate and earn rental income without paying early distribution fees.
The Investment Company Institute – the national association of U.S. investment companies, estimates that about $4.7 trillion in IRAs were held in the U.S. last year. Of this, an estimated $94 billion (only 2 percent) are in Self-directed IRAs.

A Self-directed Individual Retirement Account (IRA) is not your typical IRA since it allows the account owner to invest in a wider set of assets than those offered by custodians and trustees of traditional IRAs. This separates a Self-directed IRA from other types of IRAs since the account holder can decide what permissible investments to put his money into without having the custodian or trustee set a limit on what investments to pursue, hence the term “self-directed”. In other words, the account holder is limited only by the rules set by the Internal Revenue Service (IRS) and of course, his choice of investments. Remember too that the custodian or trustee is also in charge of facilitating all other transactions that involve the Self-directed IRA.

Through the Employee Retirement Income Security Act of 1974 (ERISA), anyone with a Self-directed IRA can invest in real estate. It’s surprising to know that very few people are aware that their retirement plan can be used to purchase investment property. And according to Jeanne Lee of FSB magazine, among savvy investors, Self-directed IRAs allow them to diversify their retirement portfolios.

The self-directed industry is growing at a rapid pace and is expected to see over $2 trillion enter the market in the next couple of years. There are over 45 million retirement account holders, and less than 4% of those funds are held in nontraditional assets. This number is expected to grow significantly over the next five years as more individuals and their financial advisers become increasingly educated about self directed IRAs. The general consensus is that the number of Self-directed IRA account holders is to grow significantly in the coming years, taking a larger share of the IRA pie.

And there’s no reason why real estate can’t be a priority when an investor plans to use his Self-directed IRA. For years, rental properties have commanded strong cash flows for investors. And although qualifying for a mortgage these days has been very tough, it pays to take advantage of record-low mortgage rates and the high demand for rental properties.

Anyone with a Self-directed IRA can invest their funds in a variety of real estate investments including: real estate options, deeds of trust, and tax liens or deeds. But keep in mind that the IRS prohibits transactions that involve life insurance and collectibles. Also, custodians or trustees are not allowed to offer real estate as an option.

Real Estate Investments and Self-directed IRA:

Real estate is just one of the investment choices that are available to account holders and it remains one of the most untapped options. Investors can choose single-family homes (which is a viable choice among those who are starting out), commercial real estate, high-rise properties and many others including land in foreign countries. This does not mean that account holders are limited with what they can invest in. One of the benefits of a Self-directed IRA is that anyone can diversify their retirement portfolio be it in, stocks, government-issued investments, or real estate.
Extra caution must be made, however, when investing in real estate using IRA funds. According to Hugh Bromma of Entrust Administration, everyone should know what kind of assets they want to purchase, so if they’ve never invested in real estate before, they should do some research to be sure that is what they really want to do with their Self-directed IRA.

In addition, account holders cannot combine IRA funds with personal loans as stated in the Internal Revenue Code. Account holders must therefore leverage borrowed funds through non-recourse loans, which are made to an IRA based on the value of the property, and not a personal guarantee. When an account holder leverages their IRA funds, the IRA must pay income taxes (from the investment property) on the unrelated debt-financed income (UDFI). Therefore, account holders need to be sure their IRAs are funded to cover any UDFI taxes.

Advantages of a Self-directed IRA for Real Estate:

Having a Self-directed IRA allows an account holder to purchase properties anywhere that’s allowed by law. Almost every type of real estate is permissible such as residential and commercial property, real estate options, and the like.

Purchasing property can also be done without paying all the required capital. For example, account holders can participate in a limited liability company (LLC) that directly invests in real estate.
Many account holders have already taken advantage of the current buyers’ market where property prices are low and foreclosure rates are high. They can attest to how they’ve benefited from their diversified portfolio within their Self-directed IRA.

Usually, real estate investments purchased within a Self-directed IRA are intended as long-term investments. This means that once an account holder buys a property, they will hold onto it until its value appreciates and is ready to be sold. In other words, the “buy-low, sell-high” concept is well suited for this type of IRA.

Selling an IRA-owned home lets the owner avoid paying capital gains tax if the proceeds are rolled back into the IRA. This especially applies to those who rehab properties in rundown condition and flip them for quick profit.

Limitations of a Self-directed IRA when Investing in Real Estate:

The Self-directed IRA cannot purchase real estate from a “disqualified person” either directly or indirectly. It also prohibits a “disqualified person” from using a property purchased within a Self-directed IRA.

The purchased property cannot be used by the account holder – not even for a night. Only qualified people may use it and this does not include one’s relatives. Unless the account holder is 59 and a half years old and retired, then living in the investment property is deemed illegal.
Account holders and family members cannot buy or sell property directly from their IRA. Likewise, it is also forbidden to buy or sell directly from the companies or enterprises that they own.
Borrowing or lending money from the IRA is not allowed, and the IRA cannot be used to lend money to family members or as collateral for any type of loan.
IRA funds and personal accounts cannot be combined or co-mingled.
Those involved in the servicing of the Self-directed IRA account are not allowed to participate in any transaction that involves the account.

A Self-directed IRA is not suitable for those who are not ready to manage their retirement plan. A Self-directed IRA can involve huge sums of money and if one is uncomfortable being in charge of their own wealth, then it becomes much riskier purchasing property.

Purchasing Real Estate with a Self-directed IRA:

To purchase real estate with a typical IRA, you could invest in a real estate investment trust (REIT), which is the most common way. However, with a Self-directed IRA, things are much easier.

You can set up your Self-directed IRA with a bank or other financial institution according to the rules of the IRS. funds can be rolled over from an existing traditional IRA, or from a direct cash contribution to the account.

To begin with, one has to find a reliable custodian or trustee to open an account and comply with the IRS requirements. When an investment property has been selected, the account holder would then authorize the custodian to pay a deposit from the Self-directed IRA by signing an authorization form. After which, the account holder must complete the necessary documents and forward them to the custodian or trustee. The closing agent will then coordinate the remainder of the transaction and release any additional funds required.

Limiting Risk:

As with any other investment, Self-directed IRA account holders must be cautious when investing their retirement funds. They must maintain the right appetite for risk whenever buying real estate, gambling in the stock market or simply thinking of alternative ways to invest their retirement funds.

Here are some ways to keep your Self-directed IRA safely invested:

First, invest only 25 percent at the most if you are not a “risk taker”. With the bargain prices of properties these days, you can surely find one that you like.

Second, keep in mind that the Self-directed IRA is making the investment — not you or anyone else. You can’t simply take the cash flow that you earn from your investment property since the custodian or trustee is in charge of it through your IRA.

Third, be sure to leave enough funds in your Self-directed IRA to cover unexpected expenses related to your property, such as tenant turnover, maintenance and repairs. This will put you in a safe position should you incur “additional” costs.

Finally, seek the advice of our expert team on what real estate investments would be best suited for your retirement goals. Make sure that you’re investing in the right properties for the right price!