Investing in Real Estate with a Self-Directed IRA: Potential Benefits, Risks, and How to Get Started

Most IRA portfolios include a mix of stocks, bonds, ETFs, and mutual funds. But if you’d like to diversify your portfolio, manage risk, and explore another option, you can also invest in real estate using your retirement savings. The key is having a self-directed account, which gives you the flexibility to invest in alternative investments.

What is a Self-Directed IRA for Real Estate?

A SDIRA for real estate is a type of retirement account which allows you to purchase real estate as an investment in your retirement account. If you’re interested in this route, you can choose a traditional SDIRA or a Roth SDIRA. The difference is:

1. Traditional SDIRA: Contributions are made with pre-tax dollars, allowing earnings to grow tax-deferred. Taxes are due upon withdrawal in retirement. However, contributions are subject to IRS limits, and the deductibility of contributions depends on your income, filing status, and participation in an employer-sponsored retirement plan. For specific deduction limits, refer to the IRS guidelines on IRA Deduction Limits.
2. Roth SDIRA: Contributions are made with after-tax dollars, and like all IRAs, earnings grow tax-deferred. Qualified withdrawals—including earnings—are tax-free if the account holder is at least 59½ years old and has held the account for at least five years. Contribution eligibility is subject to income limits set by the IRS. Detailed information can be found in the IRS guidelines on Roth IRAs.

For a full overview of IRA contribution rules and tax treatment, refer to IRS Publication 590-A.

Other account options, such as a SEP IRA or SIMPLE IRA, may be considerations if you are self-employed or part of a small business.

How to Get Started Purchasing Real Estate with a Self-Directed IRA

Once you find a property you’d like to purchase, you can explore different strategies to structure the purchase within your SDIRA. To pay for rentals, commercial properties, REITs and more through your SDIRA, you can use any of the following funding methods:

• Use the cash in the SDIRA: If you have enough cash to purchase the property in the IRA, you can buy it outright.
• Partner your SDIRA with other sources: If the funds in your SDIRA aren’t sufficient, you may be able to partner with other investors, including IRAs owned by other individuals, so long as it follows IRS rules.
• Create an IRA LLC: Creating an IRA LLC within your SDIRA can provide checkbook control for quicker transactions. In this case, the SDIRA owns the LLC, and funds are moved into the LLC’s bank account. The LLC can then make investments or pay bills directly from the IRA LLC checking account.
• Take a non-recourse loan: As you cannot take out a mortgage to purchase a property through a real estate SDIRA, you can consider a non-recourse loan, which means the lender can only seize the collateral if the borrower defaults. The lender cannot pursue the borrower's other assets or income. This provides the SDIRA owner greater protection, but lenders often charge higher interest rates and require more collateral than traditional loans, typically 40 percent down.

After you figure out your funding method, find a property and make an offer. When purchasing real estate with an SDIRA, it’s crucial to list your SDIRA as the buyer in the purchase contract – not yourself. To stay compliant with IRS rules and avoid being classified as a “prohibited transaction,” the real estate must be separate from your personal assets to maintain its tax-advantaged status. Failing to adhere to IRS rules around prohibited transactions, may result in severe tax penalties.

Closing Out Your Real Estate Purchase

Once your purchase contract is executed, your self-directed IRA custodian will wire the earnest money deposit to escrow. Keep in mind that you will also need to use your SDIRA funds to cover expenses like closing costs, inspections, HOA fees, property taxes, and any legal costs. It is mandatory to use your SDIRA funds rather than your personal funds because the property is owned by your retirement account. As a result, you must ensure you have adequate funds in the SDIRA to cover all expenses related to the real estate held in the SDIRA.

Escrow also needs to be fully paid for by your SDIRA. Prior to going into escrow, ensure you have gathered all important documentation like the warranty deed naming your SDIRA as the buyer, the title commitment, SDIRA custodian approval forms, and entity documents if using an IRA LLC.

Real Estate SDIRA Rules and Limitations

When it comes to real estate SDIRAs, it’s critical to know about the limitations of “disqualified persons.” Note that when you buy real estate through your SDIRA, the property cannot be used for the benefit of you, your spouse or children, or any other disqualified persons. Neither you nor any other disqualified person may live in it nor use it as a vacation home. You also cannot purchase a property for any of these disqualified persons. Rules around disqualified persons can be complex, so be sure to consult a professional and the latest IRS rules.  

Pros and Cons of Self-Directed IRAs for Real Estate

Like traditional retirement investments, the real estate market is subject to fluctuations which can affect your investment for better or worse.

Benefits:

• Real estate can potentially appreciate in value more rapidly than traditional investments.
• Diversifying your retirement portfolio with real estate may help protect it from market fluctuations that can affect traditional equities.
• You can rent out properties for additional passive income, as long as it’s not to disqualified persons like family members, and the rental income must go directly into the SDIRA, not to you personally.
• Your real estate SDIRA can grow either tax-deferred if held in a traditional SDIRA, or tax-free if owned by a Roth SDIRA, as long as you stay in compliance with IRS rules.

Drawbacks:

• Poor location, high vacancies, and problematic tenants can lower your property’s value and profitability.
• Unexpected repair or maintenance costs can strain your SDIRA’s funds.
• Extreme weather events, such as hurricanes or tornadoes, and broader economic conditions like interest rate changes can disrupt stability and increase your expenses.

Investing in real estate through a SDIRA can be a powerful way to diversify your retirement portfolio, enjoy the tax advantages associated with IRAs, and can help allow you to take control of your financial future. With the right guidance, you can navigate the process smoothly and maximize the potential benefits. Contact Forge Trust to open your self-directed real estate IRA and start investing.