Using your IRA to buy investment property

If you’re a savvy investor, you know a thing or two about IRAs. You know that they are 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).

You might also know that in what’s called a self-directed IRA, you are free to invest in just about any investment product, including stocks, bonds, options, mutual funds, ETFs, and REITs. There are a few limits, but overall, it's virtually anything you would ever need to build up a healthy nest egg.

But here’s what you might not know. Your IRA isn’t restricted to financial instruments that appear on the floor of a major exchange. You can buy 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, you need to know the rules. And there are a lot.

The Right IRA

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).

However, to buy and own property via your IRA, you will need a custodian. A custodian manages 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 fees for the service. The custodian won’t advise you on how to best structure your holdings, however. Its job is to handle the back-office work. (For more along these lines, see: Retirement Tips: How to Choose the Best IRA Custodian.)

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 say, "XYZ Trust Company Custodian [for benefit of] (FBO) [Your Name] IRA.” 

What Is and Isn't Yours

The property is 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 regarding apply to both you and people the IRS deems "disqualified." Who is considered a disqualified person?

  • Your spouse
  • Your parents, grandparents, 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

If you want to learn more, look at section 4.72.11.2.1 of the Internal Revenue Manual

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. See also Avoiding "Prohibited Transactions" In Your IRA.

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 now, but impacts your rate of return down the road.

Real estate investors often put a small amount down and take advantage of ultra-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 that presents another problem: Any revenue from the property may then be considered unrelated business taxable income (UBTI). To learn more, go to Section 511 of the IRS internal revenue code (IRC)

Owning the Property

Since your IRA doesn’t pay taxes, you can’t take advantage of the deductions that come with owning real estate. Since you've paid cash, there are no mortgage interest payments to deduct. Nor do you get the benefits of property tax deductions. You can’t take advantage of depreciation, either. 

If your property generates rental income, every bit of it goes right back into your IRA. Since you don’t own the property, you can’t pocket any of the income.

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.

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 $5,500 – or $6,500 if you’re 50 or older – in 2018.

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 tax-deferred or tax-free, depending on the makeup of your IRA.

One final consideration: liquidity, or “how easy is it for me 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 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 subject you to penalties if your income and IRA contribution limit don't cover repairs you can't afford to ignore.

Unless they have the time and expertise to manage real property, individual investors are probably best off with more mainstream strategies for their IRAs.

For related reading, see House Your Retirement With Self-Directed Real Estate IRAs.