You can hold real estate in your individual retirement account (IRA) if you use a self-directed account and follow specific rules. Eligible options range from residential properties to commercial buildings, raw land, and even boat slips.
The process involves more complexity than buying stocks, with strict investment-only requirements and potential tax implications. This article outlines the main rules and considerations for adding real estate to an IRA.
Key Takeaways
- A self-directed IRA is required for holding real estate, with specific rules and requirements.
- You must use IRA funds to cover all property-related expenses and cannot personally use the property.
- Purchasing real estate within an IRA often requires paying in cash, affecting potential returns.
- Property held in an IRA is an investment only and cannot be used for personal or family use.
- Property sales within an IRA return proceeds to the account, remaining tax-deferred or tax-free.
Choosing the Ideal Self-Directed IRA for Real Estate Investments
To buy real estate using an IRA, you must open a self-directed IRA account. The term “self-directed” means that alternative investments like cryptocurrencies are accepted or offered by the IRA custodian, the financial institution, or the company responsible for record-keeping and Internal Revenue Service (IRS) reporting requirements.
A self-directed IRA is independent of any brokerage, bank, or investment company that would make decisions for you—most brokerage accounts don’t allow real estate holdings, anyway.
To buy and own property via your IRA, you will still need a custodian, an entity specializing in self-directed accounts that will manage the transaction, associated paperwork, and financial reporting. Everything goes through the custodian to keep you from violating the strict rules regarding these real estate transactions.
As you would expect, the custodian will charge a fee for the service, but won’t advise you on how to best structure your holdings. Instead, the custodian handles the back-office work.
Before examining the rules, it’s important to understand how the structure of an IRA holding real estate differs from a typical IRA, meaning you and your IRA represent two separate entities. Your IRA owns the property—you don’t. Therefore, the title to the property will read “XYZ Trust Company Custodian [for benefit of] (FBO) [Your Name] IRA.”
Important
If you buy real estate with your IRA improperly, you can disqualify the IRA. If that happens, all the funds in it immediately become taxable.
IRA Ownership Rules for Real Estate Properties
The real estate property within your IRA must be 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 apply to you and to people the IRS deems “disqualified.”
A disqualified person includes the following:
- Your spouse
- Your parents, grandparents, and 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
You also can’t purchase the property from one of these disqualified people—called a self-dealing transaction—nor can the IRA buy property you already own. You can learn more about prohibited transactions in section 4.72.11.2.1 of the Internal Revenue Manual.
How to Purchase Real Estate Through Your IRA
Your IRA balance will have to be pretty high because getting a mortgage loan to purchase property inside an IRA isn’t easy. You’ll likely have to pay in cash, which takes a big bite out of the account and affects your rate of return down the road.
Real estate investors often put down a small amount and take advantage of still relatively 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 provide loans for real estate purchases, but it presents another problem: Any revenue from the property may then be considered unrelated business taxable income (UBTI). You can learn more about UBTI from Section 511 of the IRS Internal Revenue Code (IRC).
Managing IRA-Owned Real Estate: Rules and Responsibilities
As your IRA doesn’t pay taxes, you can’t take advantage of the deductions associated with owning real estate. Because you’ve paid cash, there are no mortgage interest payments to deduct. Nor do you get the benefits of property tax deductions or depreciation.
If your property generates rental income, every bit goes back into your IRA. You can’t pocket any of the income because you don’t own the property. However, you will eventually get the money when you withdraw from the account in retirement.
On the bright side, you will not pay out of pocket for the maintenance or other associated costs of owning real estate. The IRA pays for everything. However, this strategy has its drawbacks. Every dollar that comes out of your IRA means it doesn’t appreciate in value tax-free.
Important
One colossal risk is maintenance expenses that can drain your IRA’s cash and lead to expensive penalties if you “overcontribute” to the account to cover them.
And what happens if a 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 pocket, and the IRS limits your contributions.
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 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 IRA-Owned Real Estate: Process and Considerations
Work out a sales price to sell your property 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, either tax-deferred or tax-free, depending on the makeup of your IRA.
One final consideration: liquidity. Just how easy is it for you to get out of the investment? With stocks, it’s relatively easy since you can usually get your money back within one business day. 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 nearly ten million people learned in the Great Recession of 2008, you could find yourself with an asset worth less than the amount of money you owe on it.
Advantages and Disadvantages of Owning Property in an IRA
Since owning property in an IRA comes with so many drawbacks, you might wonder if it’s worth it. Historically, real estate has been an excellent long-term investment as property values rise over time, and long-term appreciation goes hand-in-hand with the long-term investment horizon of a retirement account.
In the short term, any income the property generates is tax-sheltered within the IRA. Finally, as a hard asset, real estate helps diversify a portfolio otherwise invested in equities and other securities—not the worst idea in the world.
Pros
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Portfolio diversity
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Appreciation potential
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Income option
Pros Explained
- Portfolio diversity: Real estate helps diversify a portfolio, often moving counter to financial markets.
- Appreciation potential: Real estate values have historically appreciated over the long term, aligning with an IRA’s long-term investment horizon.
- Income option: Real estate can provide a steady income stream from rents, and any rental income you collect grows tax-free within the IRA.
Cons Explained
- Need self-directed type: You must establish a self-directed IRA with a custodian.
- No property tax deduction: You can’t claim deductions for property taxes, mortgage interest, depreciation, and other property-related expenses.
- Property expenses: All expenses, repairs, and maintenance costs must be paid with IRA funds, and you must pay others to do them and manage the property.
Can You Finance Real Estate With Self-Directed IRAs?
It’s important to remember that you can use funds (cash) from the IRA to purchase the property. However, the IRA will own the property, and you can only use it for investment purposes.
Who Owns Property in a Self-Directed IRA?
Since you use the funds from the IRA to purchase the property, the account legally owns the property.
Can I Build a House With A Self-Directed IRA?
You can only use an IRA to purchase investment property, meaning you cannot build a house using the account, even if you intend to use it as an investment property.
The Bottom Line
Using a Roth or traditional IRA to buy an investment property requires understanding both real estate investing and IRA rules. Maintenance costs must be covered by the IRA itself, and falling property values add further risk.
For those who prefer less complexity, a standard IRA still allows exposure to real estate through real estate investment trusts (REITs), mutual funds, or exchange-traded funds (ETFs), which offer more liquidity and fewer administrative demands.