Using an IRA to buy investment property is not for the faint of heart, nor is it for anyone unfamiliar with the differing types of individual retirement accounts. At its most basic level, an IRA is a type of tax-advantaged retirement account that allows the funds within it to grow without incurring income taxes on any investment income earned by the principal (“basis” in financial advising terms).

Many people choose to have the account managed by a custodian, who will offer a limited menu of investments you can make with your IRA funds and will manage the account. However, there is another option. With a self-directed IRA, you manage the investments yourself and are free to invest in just about any product, including stocks, bonds, options, mutual funds, exchange-traded funds (ETFs), and real estate investment trusts (REITs). There are a few limits, but overall it’s virtually anything you would ever need to build up a healthy nest egg.

What's more, a self-directed IRA isn’t restricted to financial instruments that appear on the floor of a major exchange. You can buy actual real estate, too. It’s not as easy as purchasing a few hundred shares of stock, though. If you want to plunge into property purchases through your self-directed IRA, you need to know the rules—and there are a lot of them.

Key Takeaways

  • To buy an investment property with an IRA, you must use a self-directed account.
  • A self-directed IRA requires a custodian to manage it.
  • Any real estate property you buy must be strictly for investment purposes.
  • Purchasing real estate within an IRA usually requires paying in cash.

The Right IRA for Buying Investment Property

First of all, your IRA has to be self-directed. You have to set it up independent of any brokerage that would make decisions for you (most brokerage accounts don’t allow real estate holdings, anyway).

To buy and own property via your IRA you will still need a custodian, an entity specializing in self-directed accounts that will manage the transaction, associated paperwork, and financial reporting. Everything goes through the custodian to keep you from violating the strict rules regarding these types of real estate transactions. As you would expect, the custodian will charge a fee for the service. However, it won’t advise you on how to best structure your holdings. This custodian’s job is to handle the back-office work.

Before we look at the rest of the rules, understand this basic fact: You and your IRA are two separate entities. Your IRA owns the property—you don’t. In fact, the title to the property will read “XYZ Trust Company Custodian [for benefit of] (FBO) [Your Name] IRA.” 

When you buy real estate with an IRA, you do not own the property; your IRA does.

What Is and Isn’t Yours

Your real estate property must be purely an investment. You can’t use it as a vacation home, a place for your kids to live, a second home, or an office for your business. These rules apply to you and to people the IRS deems “disqualified.” So who is considered a disqualified person?

  • Your spouse
  • Your parents, grandparents, and great-grandparents
  • Your children and their spouses, grandchildren, and great-grandchildren
  • Service providers of your IRA
  • Any entity that owns more than 50% of the property

You also can’t purchase the property from one of these disqualified people—this is called a self-dealing transaction—nor can the IRA purchase from you property you already own. You can learn more about prohibited transactions at section 4.72.11.2.1 of the Internal Revenue Manual.

Making the Purchase

Your IRA balance will have to be pretty high because getting a mortgage to purchase property inside an IRA isn’t easy. You’ll likely have to pay in cash, which not only takes a big bite out of the account; it also affects your rate of return down the road.

Real estate investors often put down a small amount and take advantage of still relatively low-interest rates to leverage the purchase, figuring they can make more money on the property than they’ll pay in interest. If you can’t finance your real estate purchase, you lose that potential for a significant return on investment (ROI).

Some banks will consider loans for this sort of transaction, but it presents another problem: Any revenue from the property may then be considered unrelated business taxable income (UBTI). You can learn more about UBTI from Section 511 of the IRS Internal Revenue Code (IRC).

Owning the Property

As your IRA doesn’t pay taxes, you can’t take advantage of the deductions that come with owning real estate. Because you’ve paid cash, there are no mortgage interest payments to deduct. Nor do you get the benefits of property tax deductions or depreciation. If your property generates rental income, every bit of it goes right back into your IRA. As you don’t own the property, you can’t pocket any of the income. (Of course, you will get the money eventually, when you make withdrawals from the account at retirement.)

On the bright side, none of the maintenance or other associated costs of owning real estate comes out of your pocket. The IRA pays for everything. However, this is not without drawbacks. Every dollar that comes out of your IRA is a dollar that no longer gets a couple of decades to appreciate in value tax free.

One huge risk: maintenance expenses that drain your IRA's cash and lead to expensive penalties if you "over contribute" to the account to cover them.

And what happens if property incurs a series of major expenses that push your IRA balance so low that the account doesn’t have enough money to pay for it? Remember, you can’t pay for anything relating to this property out of your own pocket, and IRA contributions are limited: You can only deposit $6,000—$7,000 if you’re 50 or older—in 2019.

If that doesn’t cover the repair, and you have to deposit more, you’re on the hook for penalties associated with contributing too much. This is a significant risk, as property can quite often require pricey upkeep, and the income you get from rentals may not cover what you need to spend in a high-maintenance year.

Selling the Property

To sell your property, work out a sales price just as you would with any other real estate holding. Once both parties agree on a price and terms, request that your custodian sell the property on behalf of your IRA. All money will go back into your IRA either tax deferred or tax free, depending on the makeup of your IRA.

One final consideration: liquidity. Just how easy is it for you to get out of the investment? With stocks, it’s relatively easy. Sometimes you can have your money back in seconds. In contrast, real estate is a notoriously illiquid investment. It may take a long time to divest, and you could lose money along the way. As eight million people learned in the Great Recession of 2008, you could find yourself with an asset that is worth less than the amount of money you owe on it.

The Bottom Line

All this makes real estate investing of any type quite risky or at best high maintenance. For an IRA, though, real estate is a particularly high-risk choice. Not only may property values drop rather than rise; a year of significant maintenance costs could also subject you to penalties if your income and IRA contribution limit don’t cover repairs you can’t afford to ignore. Unless you have both the time and expertise to manage real property, you are probably best off with more-mainstream strategies for your IRA.