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Pros & Cons Of Using A Self Directed IRA For Real Estate

Disclaimer: Individuals should consult a tax professional before getting started with a self directed IRA.

One of the lesser known vehicles for financing real estate is through a self directed IRA for real estate. This type of retirement account enables freedom over investment choices, including the ability to choose from non traditional investments such as stocks, partnerships, mortgage debt, precious metals and even real estate. Consequently, a self directed IRA for real estate can be used to deploy retirement capital into acquiring real estate properties such as single-family, multifamily, commercial real estate and more, which offers a higher rate of return and diversification potential compared to traditional investments.

Having said that, what are the benefits to this strategy? And perhaps even more importantly, what precautions should investors take moving forward?

The Pros & Cons Of Using A Self Directed IRA For Real Estate

real estate ira

A self directed IRA works much like traditional retirement accounts, except it allows for two things: more control and the ability to invest in alternative assets. Although investments must be overseen by a financial custodian, this approach allows you to essentially direct how and where your money is invested. Naturally, this strategy incorporates a higher-risk level and will take considerably more work on the part of the investor, as the majority of responsibility falls on them.

There are rules to abide by when using a self directed retirement fund. The inability to follow these rules, which are set forth by the I.R.S., will result in penalties — which could ultimately derail one’s retirement. That said, it is imperative individuals have a clear understanding of not only the financial landscape of their retirement savings, but real estate goals as well. Ultimately, this will help to determine whether using your self directed IRA for real estate aligns with both your short and long-term goals moving forward.

The Dalai Lama once said, “know the rules well, so you can break them effectively.” Here are the basic rules to using a self directed IRA in real estate:

  • Cannot be used to purchase property owned by you or disqualified person.
  • Cannot have “indirect benefits.” This means any type of profits from the investment must provide for your retirement, whether now or at some future date. This indicates that investors cannot, benefit from profits today or rent space from the building that your self directed IRA owns.
  • Real estate can be acquired without 100 percent funding from the self directed IRA.
    Investments that use financing must pay UBIT (unrelated business income tax).
  • All expenses from investments, including related to property owned (maintenance, improvements, property taxes) must be paid from the IRA.
  • All earned income goes back to the self directed IRA.

Although self directed IRAs have been around for several decades, the popularity has only surged in recent years. To better understand the appeal of using self directed IRA for real estate, including the risks and rewards associated with this strategy, the following highlights the pros and cons for investors:

Pros

Authority: The biggest benefit of a self directed IRA is control. Instead of earning subtle returns on typical retirement options like ETFs, mutual funds, bonds and stocks, which are generally controlled by others, investors have the ability to choose alternative investments like real estate. Done correctly, this investment strategy can cultivate a significant nest egg for those looking to upgrade the financial conditions in retirement.

Tax Deferral: Another major benefit of a self directed plan is the ability to grow your retirement savings in a tax-deferred or tax-free environment. This investment style enables individuals to reinvest profits from real estate investments, including rental income and capital gains, into other investments — tax free. That said, it’s important to mention that tax deferral with a self direct IRA only applies to the money you’ve attributed — and not any outside financing. For example, a property would need to be financed using funds from a self directed IRA, rather than debt-financed.

Although self directed IRAs offer immense value in terms of tax deductions and deferral, individuals should consult a tax professional when in doubt.

Asset Protection: A self directed IRA, like any other IRA, is afforded protection from federal and state bankruptcy law. By definition it’s a trust, which means it is a separate entity from the owner and has its own set of asset protection. In return, this protects investors from creditors coming after you because you don’t own it.

Higher Returns: The aim of using a self directed IRA for real estate is to leverage your retirement savings in order to accrue a much larger nest egg, at a much faster rate. Compared to traditional IRA investments, this approach can yield significant returns for investors, helping to further cushion retirement.

Cons

Approval: In order to take advantage of a self directed IRA, a third-party custodian will be required. This account holder, which must be approved by the IRS, serves as an intermediary between the investor and the issuer of an investment, with the custodian having permission over the release of funds. Their job is to track and report contributions to and distributions from the account to the IRS. Because the custodian is simply a guardian of the account, they perform no diligence regarding investments.

Restrictions: The inability for self-dealing is another disadvantage of using a self directed IRA. Generally speaking, those you have a 50 percent interest in, whether it be a spouse, immediate family member or company, cannot be involved in any shape or form in the investment. These disqualified persons are unable to receive any benefits from investment transactions.

“The IRA account owner cannot use his or her IRA funds to purchase a property they currently own. Additionally, the IRA owner cannot use an IRA-owned real estate asset nor can any disqualified person,” says Sandra Reese, an independent consultant based in Chicago that specialized on alternative asset investing in self directed IRA. “The IRA account owner cannot perform any work on the IRA real estate asset, and all income and expense must flow through the custodian to protect the tax-deferred status of the account.”

In addition, this also includes using the real estate IRA property as a vacation home, as the concept of your self directed IRA aims to benefit your retirement, not personal benefit–with earned income adding to your nest egg. However, the use of a self directed IRA can be used to finance an investment property.

A self directed IRA is an invaluable tool for growing your retirement, as it gives you the freedom to choose how and where your nest egg is invested. Using it to invest in real estate is an excellent way to obtain long-term wealth, while also enjoying an array of tax benefits in the process.

Have you tried setting up a self directed IRA for real estate? Let us know in the comments below how your experience was.

Disclaimer: Individuals should consult a tax professional before getting started with a self directed IRA.

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