Interest in using retirement funds held in IRAs for “alternative investments” such as real estate has risen steeply over the last several years. Of course, most IRAs are invested in securities, but some estimates suggest that more than $100 billion, 2% of all IRA funds, has been shifted from stocks and bonds to assets like real estate. Locally, the question of how this can be accomplished has been raised with greater frequency.
A self directed IRA is the simple answer to a complex subject. IRAs (in their many forms) have long been recognized as an excellent tool to save for retirement and gain tax benefits, but they can be limited, by brokerages for example, as to how they may be invested. Alternatively, self directed IRAs put investment decisions in the hands of the account holder and offer flexibility that permits a wide variety of investments ranging from real estate (investment) to private financing (non-family) to rock fantasy camps (if you so choose). However, a self directed IRA is not free of rules, does come with risk, and your choices aren’t unlimited, but properly executed it can offer diversification, and potentially gains, not available in other plans.
Establishing a Self Directed IRA
Most self-directed IRAs begin with a desire to diversify portfolio holdings and the identification of an “alternative asset” custodian or qualified trustee. This professional is charged with maintaining the account on the holder’s behalf. Similar to the role of traditional managers of retirement funds, these services include record keeping, issuance of account statements, and the filing of necessary documentation for tax purposes, and perhaps annual valuation. Unlike financial services firms, many self directed IRA custodians (although there are some active custodians) do not offer advice on investment decisions, which means the investor is responsible for identifying, assessing, and analyzing the asset being considered.
What You Need to Know
- It is important to select your self directed IRA custodian carefully. There are a lot of firms offering these services and some are not very good at it, which can cause big headaches in the form of tax consequences. Make sure you do your homework.
- You will be controlling the action. The last thing you want to do is cut your regular trusted advisors out of the loop. The custodian is being hired for a specific purpose, not as a replacement for your attorney, accountant, financial advisor, and real estate broker, all of which can help you make better decisions.
Acquisition of Real Estate
After the account has been established and funded, most investors are eager to identify a new real estate asset, but there are a couple of items that should be considered first.
Depending on the size of your purchase relative to the size of your account, financing may need to be considered. Individual ownership, in which the entire property is purchased using the investor’s IRA funds, is the easiest–but may lose out on the benefits of leverage that so many investors find appealing. Besides, most investors aren’t able to pay all cash for their purchases—so some financing will be required.
Multi-party ownership offers an alternative. More than one IRA investor can pool funds for the purpose of acquiring real estate through a variety of ownership structures. It is important to note, expenses generally must be paid based on the pro-rata, or percentage, share of ownership. If you own 39.5% of the property, you must pay 39.5% of the expenses with money held within your IRA. Failure to do so could result in penalties or disqualification.
Traditional lending institutions and private financing are also an option—although it can trigger additional taxes in some cases (UBIT). Largely, the requirements for securing financing for a self-directed IRA purchase are the same with one big caveat. The financing must be non-recourse. That is, if you are unable to repay the loan based on the agreed terms (default) the lender cannot pursue the individual (you) or take additional funds from your IRA, but must rely solely on the value of the property to recoup their losses, if any. This type of financing is challenging to find in today’s market, but many have found a workaround in the form of assumable notes tied to investment properties.
Real estate has associated expenses such as taxes, insurance, maintenance, and management. These expenses must be paid with IRA funds, which means you’ll want to maintain a cash reserve, but the manner in which they are paid is a decision left to the investor. Essentially, there are two choices. Utilize your custodian to issue checks when required, which often has an associated fee, or create an IRA LLC in conjunction with your self directed IRA. The IRA LLC does permit greater control, quick response, and avoids fees—but comes with the responsibility of ensuring the expenses paid are properly documented and appropriate.
This Sounds Like A Pain, Why Would I Do It?
It’s a fair question. Selecting a competent professional custodian or trustee and utilizing the expertise of others throughout the process can prevent a lot of the hassle described above. Beyond that, the decision to use IRAs to invest in real estate has been driven by frustration with traditional securities, a desire to gain true diversification, tax benefits, and the ability to invest in areas of expertise.
Diversification: Real estate investment gives investors the chance to diversify their portfolios well beyond the traditional paper securities and may serve as a hedge against inflation or irrational market activity (not that real estate is immune from the latter) and offers up the benefits of appreciation and cash flow (to your IRA).
Tax Benefits: Using an IRA for real estate purchases forfeits many of the well known tax advantages such as depreciation, mortgage interest deductions, and capital gains treatment, but does permit deferral of taxes, which is an extremely powerful tool (think compound interest).
It’s Your Market: Real estate investment through an IRA provides the chance to leverage your knowledge of the real estate or a local market through tax-protected investments in assets with which you are familiar and can gain further understanding with some effort. Simply, you can capitalize on knowledge in a way that may not be truly possible with stocks.
Distributions for assets like real estate are handled the same way as any other retirement plan—distributions may begin at 59 ½ and minimum distributions must begin at 70 ½.
You can’t purchase a property you will occupy or sell a property to your IRA that you already own.
You cannot lend money to family members—they are considered disqualified parties.
Many of the assets you can purchase with a self directed IRA aren’t regulated—exercise caution.
Despite being called a “self” directed IRA, this is not a DIY task and should include professionals that provide guidance related to the tax, legal, and real estate aspects of any decision.
A self directed IRA is a tool that may be right for some, but not others. Just like any tool, it is only useful if you know how, and when, to use it properly.
Tim Reamer provides commercial real estate brokerage and consulting services with Cottonwood Commercial and specializes in investment property (multifamily | commercial | NNN), retail/restaurant site selection, and commercial buyer/tenant representation.SHARE