Real estate investment by individuals is on the rise, but for the most part, it has been limited to real estate investment trusts (REITs) and real estate mutual funds. However, the emergence of self-directed IRAs, which not only allow but encourage real estate products, is beginning to change the situation. Direct real estate investing is becoming an increasing option for retirement-oriented investors who want to take advantage of real estate's return potential and its abilities as a portfolio diversifier and inflation hedge.
Self-directed IRAs allow investors the same discretion as they typically have over their taxable investments, but allow for the tax-deferred growth of earnings. In the form of a self-directed IRA, investors are able to invest directly in real property, mortgages, private placements, and other non-traditional assets: Section 408 of the Internal Revenue Code allows for the purchase of property with funds held in many common forms of IRAs, including a Traditional IRA, a Roth IRA, and a simplified employee pension (SEP) IRA. With such structures, investors can achieve significant flexibility in investment options, greater control over their retirement assets, and the investment potential provided by direct real estate investments.
- Self-directed IRAs allow for tax-deferred growth of earnings.
- Self-directed IRAs are also managed by the account owner rather than a financial institution.
- Investment options for self-directed IRAs are not limited to traditional assets.
A self-directed IRA is one that allows the account owner to actively manage the portfolio, making investment decisions and choosing products—anything from stocks and bonds to alternative investments—instead of having a financial institution do it.
In order to invest using a self-directed IRA, the IRA must be held with a qualified trustee or custodian. Generally, these trustees provide administrative services, such as maintaining records of contributions and other activity, filing required IRS reports, issuing client statements, and providing information pertaining to the rules and regulations that govern IRAs (for example, the contribution limits and deductibility rules, the rules for distributions, and the penalties for early withdrawals).
Investment Options for Self-Directed IRAs
The investment options for self-directed IRAs are not usually limited to traditional assets but include anything permitted by the IRS. This creates a higher diversification potential than regular IRAs, where investments are often confined to mutual funds or certificates of deposits (CDs). However, although all investment types are allowed under federal regulations, not all custodians provide for all asset classes, including real estate or mortgages. Therefore, would-be account-holders should check with the custodian before establishing the IRA.
These IRAs cannot invest in IRS-prohibited assets, such as life insurance and collectibles, and must follow the same IRS rules and regulations covering regular IRAs.
Although the IRA is a non-discretionary account, the regulations make the IRA owner responsible for compliance with all regulatory requirements. Since the custodian usually does not determine whether the investment is in compliance with regulatory requirements or provide legal/tax advice, investors interested in self-directed IRAs should seek advice from an independent tax or legal advisor.
Extending beyond stocks and bonds, the investment options available for self-directed IRAs can include the following sorts of real estate vehicles:
- Limited liability companies (LLC)
- Private limited partnerships
- Secured and unsecured notes (mortgages and deeds of trust)
- Partnerships and joint ventures
- Private stock
- Publicly traded stocks, bonds, and mutual funds
- Other investments
- Judgments/structured settlements
- Tax sale certificates
- Accounts receivable
- Single-family and multi-unit homes
- Apartment buildings
- Commercial property
- Improved or unimproved land (leveraged or unleveraged)
It is important to find a custodian that is experienced with handling these investments, as special tax reporting rules and operational procedures apply.
You can purchase land or property (residential and commercial) in your IRA as long as it does not result in self-dealing. This means you cannot purchase a home or building in which you will reside or do business. Your IRA also cannot purchase any property owned by you or a business in which you or certain members of your family have a specified percentage of ownership. The IRA is also prohibited from selling any property to you or any of the aforementioned parties.
Operational Procedures and Taxes
Once you've provided the documentation and proper instructions for purchasing the property, your IRA custodian will initiate the purchase for your IRA. The title of the property will reflect the name of your IRA custodian. All property-management and property-specific expenses must be made through the IRA, so the IRA must have sufficient cash to pay these amounts. Having to rely on outside capital to fund management expenses can lead to the loss of tax benefits or the incurrence of penalties.
If the property is debt-financed, it can create what is known as unrelated business taxable income (UBTI), which is taxable under the IRS code. This is unlike other earnings, which are tax-deferred until withdrawn from the IRA. Investors wishing to invest in debt-financed assets should contact their tax advisor to investigate the tax implications.
For investors wanting greater influence over their investments, checkbook control is another option. This allows the IRA owner to make purchases by writing checks on behalf of the IRA. The transactions are facilitated through an LLC that is owned by the IRA. Other legal structures, such as S corporations, are usually not available since they do not allow IRAs as investors. Creating an LLC to do one's IRA investing can give an investor even greater control over their assets and reduce certain custodial fees.
Typically, the IRA owner has the option of performing certain management functions, such as advertising, collecting, and depositing rent checks and paying related bills. This puts the investor at a great advantage, especially when purchasing real estate foreclosures, which is usually a time-sensitive proposition requiring the ability to write checks at the courthouse steps.
Direct real estate investing has historically given rise to significant wealth for investors that understand the risk-return tradeoff of this asset class. The use of self-directed IRAs gives investors the ability to directly invest in property and other real estate-related assets while providing the tax-deferment abilities of Traditional IRAs.
The Bottom Line
In the form of a self-directed IRA, investors are able to invest directly in real property, mortgages, private placements, and other non-traditional assets. In some cases, IRA owners are given checkbook access to their IRA balances. With such structures, investors can achieve significant flexibility in investment options, greater control over their retirement assets, and the investment potential provided by direct real estate investments.