IRA investors looking to add real estate as an asset class to their retirement portfolio face limitations when investing via a traditional IRA custodian. REIT funds and ETFs, or publicly traded REITs themselves are the most common avenue. Conventional IRA custodians like banks and brokerage firms usually won’t custody direct real estate investments in your account. For investors and financial advisors seeking to add direct real estate investments to their retirement accounts, a self-directed IRA provides a solution.
Direct real estate investments
Examples of direct real estate investments available by using a self-directed IRA include:
- Single family residential
- Multifamily residential
- Office Space
- Retail & Shopping centers
- Self-storage facilities
- Farm & ranch land
- Condos & townhomes
- Rental property
- Raw or undeveloped land
- Industrial property
- Senior living centers
- Student housing
- Manufactured homes
- Real estate notes or mortgage notes
- Trust deeds
There is nothing wrong with an ETF or mutual fund that invests in REITs, or even an investment directly in a REIT. While REITS are real estate based, they are still stocks and generally don’t offer the same level of diversification, nor the opportunity for growth, as a direct investment in real estate. Let’s look at some examples of direct real estate investments and why a self-directed IRA is a good vehicle for investing in them.
Using IRA funds to buy residential property allows you to own rental property or to just buy and sell residential property within the IRA structure. All profits remain in the account and enjoy the tax-deferred status of your IRA. All expenses should be paid from funds within the account as well. This includes maintenance and improvements to the property as well as any taxes.
Another type of real estate investment to consider within a self-directed IRA are mortgage trust deeds. Essentially as the holder of the mortgage you are lending the money to purchase a property to a buyer. You receive an interest in the property as collateral. If the borrower continues to make payments, the payment of principal and interest are added to your IRA and the account continues to grow. You are able to invest these funds elsewhere in another mortgage, another type of real estate asset or anywhere else you choose. On the flip side, if the borrower defaults, the property becomes an asset of the IRA.
Raw land can be a solid long-term investment. Raw land is generally a very hands-off type of real estate investment, taxes are usually the only expense that is ongoing. When the land is sold the proceeds go back into your IRA. Any gain on the sale remains tax-deferred under the IRA umbrella until the funds are withdrawn in retirement. The right parcel of raw land in the right location can command a handsome selling price.
Things to know about investing in real estate within an IRA
While investing in real estate within a self-directed IRA can be a great way to diversify your retirement holdings, there are IRA rules to be followed, often called the Prohibited Transaction rules. Violating these rules come with the penalty of loss of the IRA’s exempt status and a tax bill on the entire amount invested, payable at ordinary income tax rates and a 10% penalty.
One example is that the IRA cannot be used to purchase any property that was owned at any point by you or any disqualified person (your spouse, your parents, grandparents, or children). This can also include any business entity that you have held a controlling interest in. Running afoul of this prohibition can trigger a prohibited transaction which could result in your entire IRA being disqualified.
If the property is income-producing, then it is imperative that you hire a third-party to manage the property. On a similar note, be sure to hire a third-party to make any and all improvements to the property, as doing it yourself would be considered sweat equity which is a prohibited transaction.
A direct investment in real estate in its various forms is a great way to diversify your retirement holdings. A self-directed IRA is the vehicle of choice in which to implement this strategy. Be sure that your IRA custodian understands the administrative ins and outs of investing in real estate within an IRA before you move ahead though. This will save a you a lot of potential headaches and adverse tax consequences down the road.
STRATA Trust is a self-directed IRA custodian, specialized in holding alternative assets within IRAs.