Creative Finance 201: How to Use a Self-Directed IRA to Invest in Real Estate Deals
If you are looking for a way to invest your retirement savings in real estate, you may have heard of self-directed IRAs (SDIRAs). These are special types of IRAs that allow you to hold a wide range of alternative investments, including real estate, precious metals, private placements, and more.
But how do you use a SDIRA to fund real estate deals? What are the benefits and risks involved? And what are the best practices and tips to follow?
What is a Self-Directed IRA?
A self-directed IRA is an individual retirement account that allows you to choose from a variety of investment options that are not typically available in regular IRAs. These include:
Real estate
Precious metals
Business interests
And more
A self-directed IRA can be either traditional or Roth, depending on whether you want to pay taxes now or later on your investment income. It has the same contribution limits as regular IRAs. For 2024, the limit is $7,000 per year ($8,000 if you are 50 or older). A self-directed IRA also has the same withdrawal rules as regular IRAs. You must start taking required minimum distributions (RMDs) when you reach age 72 (or 73 depending on when you were born). The amount of RMDs depends on your life expectancy and account balance.
However, unlike regular IRAs, a self-directed IRA does not have any restrictions on who can open or manage it. You can open one yourself or work with an advisor who can help you set up and maintain it. You can also choose any custodian or trustee who agrees to hold your account for you. A custodian is an entity that provides recordkeeping and reporting services for your account. A custodian is required if you are buying real estate within a SDIRA. A trustee is an entity that manages your assets according to your instructions.
One important thing to note is that not all custodians offer self-directed IRAs as an option. You may need to do some research and compare different providers before choosing one that suits your needs.
Another important thing to note is that not all investments are allowed in self-directed IRAs. You must follow certain rules and regulations set by the IRS when choosing what assets to invest in.
What Type of Real Estate Can I purchase in a SDIRA?
You are able to invest in just about every type of real estate within a self-directed IRA such as:
Single-family homes
Multifamily units
Raw land
Commercial properties
Storage units
Private REITs and crowdfunding platforms
What are the Benefits of Using a Self-Directed IRA for Real Estate Investing?
One of the main benefits of using a self-directed IRA for real estate investing is diversification and taxes. By investing in alternative assets such as real estate, you can reduce your exposure to market fluctuations, reduces taxes paid, and increase your returns over time.
Real estate investing can also provide several advantages over other types of investments:
Opportunity Cost: If you find a great opportunity, but don’t have the cash to buy the deal, but do in your SDIRA, this could give you the ability to pursue the opportunity.
Appreciation & Cash Flow: Real estate values tend to increase over time due to supply and demand factors and is a great diversification for a retirement portfolio for some individuals.
Tax benefits: If you make more money from a property (after paying for costs and depreciation) than you think it will grow in value, it might be better to own it in a tax-deferred IRA. That way, you can avoid paying high income taxes on property you own outside the account.
Creditor protections: In some states, investors can protect their real estate held in an IRA from creditors.
Diversification can help you achieve better performance by spreading out your investments across different sectors, industries, geographies, and market conditions.
What are the Risks?
Investing in real estate with a self-directed IRA can offer many benefits, such as diversification, tax advantages, and higher returns. However, it also involves some risks that you should be aware of before you start investing, such as:
Lack of diversification: If you invest most or all of your SDIRA funds in real estate, you may not have enough exposure to other asset classes, such as stocks, bonds, or cash. This can make your portfolio more vulnerable to market fluctuations and losses.
Illiquidity: Real estate is not a liquid asset, meaning it can be hard to sell quickly and easily. If you need to access your SDIRA funds for any reason, such as taking required minimum distributions (RMDs) or facing an emergency, you may have trouble converting your real estate investments into cash.
High costs and fees: Investing in real estate with a SDIRA can involve various expenses and charges, such as custodian fees, legal and accounting fees, property taxes, insurance premiums, maintenance and repair costs, and property management fees. These costs and fees can reduce your returns and eat into your SDIRA balance.
Tax complications: Investing in real estate with a SDIRA can trigger some tax consequences, such as unrelated business income tax (UBIT) and unrelated debt-financed income (UDFI). These taxes may apply if your SDIRA holds a debt-financed property and generates rental income, capital gains, or other income from the sale.
Rules and regulations: Investing in real estate with a SDIRA requires you to follow the IRS rules and regulations for self-directed IRA investing, such as avoiding prohibited transactions, valuing and reporting your assets, and complying with RMDs and early withdrawal penalties. If you violate any of these rules and regulations, you may face severe penalties and taxes, and even lose your SDIRA status.
What Are The Rules?
While using a self-directed IRA for real estate investing has many benefits, it also comes with some risks and challenges that you should be aware of before proceeding.
Property Title: Your real estate IRA owns the property, not you. That means the papers that show who owns the property have your IRA’s name on them, not yours.
Expenses and Income: Your real estate IRA pays for and receives everything related to the property. Your account pays for all the bills and taxes for the property. Your account gets all the rent or other money from the property. You cannot pay for any expenses from funds outside of your SDIRA.
Prohibited transactions: You cannot engage in any transactions that involve yourself, your family members, or any other disqualified persons. These include buying, selling, leasing, lending, or exchanging any property or service with your self-directed IRA. For example, you cannot use your self-directed IRA to buy a house and then live in it or rent it to your relatives.
Joint Ventures: Self-directed IRAs can join in real estate deals with other investors or partners.
Unrelated business income tax (UBIT): You may have to pay taxes on any income that your self-directed IRA generates from a trade or business that is not substantially related to its exempt purpose. For example, if you use your self-directed IRA to buy a rental property and hire a property manager to run it, you may have to pay UBIT on the rental income.
Valuation: You must report the fair market value of your self-directed IRA assets to your custodian or trustee every year. This may require you to hire an appraiser or other qualified professional to value your real estate properties. You must also report any distributions or conversions of your self-directed IRA assets to the IRS and pay any taxes or penalties that may apply.
Due diligence: You are responsible for conducting your own research and analysis on any potential investments that you make with your self-directed IRA. You must also monitor and maintain your investments according to your investment strategy and goals. You cannot rely on your custodian or trustee to do this for you. You must also be aware of the market conditions, legal issues, and environmental factors that may affect your investments.
Prior Property Ownership: You can’t sell, rent or trade any property that you already own to your IRA. The IRS calls this “self-dealing,” and it’s not allowed.
These are some of the main risks and challenges that you may face when using a self-directed IRA for real estate investing. You should consult with a tax professional, a financial advisor, and a legal expert before making any decisions. You should also educate yourself on the rules and regulations that apply to your specific situation and investments.
The Hidden Costs of Investing in Real Estate in a SDIRA
The costs and fees for self-directed IRA (SDIRA) real estate investing can vary depending on the type of account, the type of property, and the type of transaction. However, some of the common costs and fees are:
Setup fee: This is a one-time fee charged by the SDIRA custodian or trustee to open the account. It can range from $50 to $300.
Annual fee: This is a recurring fee charged by the SDIRA custodian or trustee to maintain the account. It can be based on the account balance, the number of assets, or a flat rate. It can range from $100 to $500 per year.
Transaction fee: This is a fee charged by the SDIRA custodian or trustee for each investment or distribution made with the account. It can be based on the amount, the type, or the complexity of the transaction. It can range from $25 to $250 per transaction.
Legal and accounting fees: These are fees charged by professionals such as lawyers, accountants, or tax advisors to assist with the legal and tax aspects of SDIRA real estate investing. They can vary depending on the services provided and the hourly rates of the professionals.
Property taxes and insurance premiums: These are expenses paid by the SDIRA account to the local authorities and the insurance companies for the property owned by the account. They can vary depending on the location, the value, and the coverage of the property.
Maintenance and repair costs: These are expenses paid by the SDIRA account to the contractors or service providers for the upkeep and improvement of the property owned by the account. They can vary depending on the condition, the size, and the quality of the property.
Property management fees: These are fees paid by the SDIRA account to the property managers or agents for the management and leasing of the property owned by the account. They can be based on a percentage of the rental income, a flat rate, or a combination of both. They can range from 8% to 12% of the rental income.
How to Open and Fund a SDIRA For Real Estate Investing in 5 Easy Steps
Step 1: Choose Your Self-Directed Retirement Account
Decide which type of self-directed account suits your needs and goals, such as a traditional IRA, Roth IRA, or Individual 401(k)
Compare the tax advantages and disadvantages of each account, such as pre-tax or post-tax contributions, tax-deferred or tax-free distributions, and required minimum distributions (RMDs) or early withdrawal penalties
Contact your IRA custodian for more information and guidance on choosing the right account for you
Step 2: Open Your Self-Directed IRA Account
Find a reputable and reliable self-directed IRA custodian or trustee that offers the type of account and the investment options you want
Submit all the required documents and forms to open your account, such as proof of identity, beneficiary designation, and account agreement
Fund your account with an initial deposit or transfer from another account
Step 3: Transfer or Rollover Funds to Your Self-Directed IRA Account
There are three ways to fund your self-directed IRA account, depending on the source and type of funds you have:
Transfer funds from another account of the same type, such as from an old IRA to a new IRA
Rollover funds from a different type of account, such as from a previous employer’s 401(k) to a new IRA
Make annual contributions according to the IRS limits and rules for your account type and age
Keep track of the amount and date of your transfers or rollovers to avoid any excess contributions or penalties
Step 4: Review the Rules and Regulations for Self-Directed IRA Investing
Before you start investing in real estate or any other alternative asset with your self-directed IRA, you should familiarize yourself with the IRS rules and regulations that apply to your account and your investments
Consult with a tax or legal professional if you have any questions or doubts about the rules and regulations for self-directed IRA investing
Step 5: Start Investing in Real Estate with Your Self-Directed IRA
Once you have opened and funded your self-directed IRA account, and you have learned the rules and regulations for self-directed IRA investing, you are ready to start investing in real estate with your self-directed IRA funds
Purchase a property with the help of your IRA custodian or trustee, who will sign the documents and transfer the funds on behalf of your self-directed IRA
Manage your self-directed IRA real estate investment according to the IRS rules and regulations, such as paying the expenses and taxes from your self-directed IRA account, collecting the income and depositing it in your self-directed IRA account, and maintaining the property and keeping records of the transactions
How to Sell Your SDIRA Real Estate Investment in 5 Simple Steps
Step 1: Prepare the Property for Sale
Make sure the property is in good condition and ready to be shown to potential buyers
Hire a property manager or a contractor to handle any repairs or maintenance issues
Pay any outstanding bills or taxes related to the property from your SDIRA
Update the valuation of the property and report it to your custodian
Step 2: Find a Buyer and Negotiate the Price
Work with a real estate agent who is familiar with SDIRA transactions and can market the property to qualified buyers
Review the offers and select the best one that meets your expectations and goals
Negotiate the terms and conditions of the sale, such as the closing date, contingencies, and financing options
Step 3: Sign the Purchase Contract and Transfer the Title
The buyer will draw up a purchase contract, which your custodian will sign on behalf of your SDIRA
Make sure the seller on the purchase contract is your SDIRA, not you personally
Complete a “Sell Direction Letter” along with the required documents, and submit them to your custodian
Instruct your custodian to liquidate the asset and transfer the title to the buyer
Step 4: Receive the Sale Proceeds and Deposit Them in Your SDIRA
Any money you receive from the sale of the property will be deposited in your SDIRA
The sale proceeds check or wire must be payable to your custodian
The property sale is consummated between your SDIRA and the buyer, not you personally
Step 5: Reinvest or Distribute the Funds from Your SDIRA
You can reinvest the funds from the sale in another real estate property or a different asset class within your SDIRA
You can also distribute the funds from your SDIRA to yourself or a beneficiary, subject to taxes and penalties depending on your age and type of SDIRA
You must follow the IRS rules and regulations for required minimum distributions (RMDs) and early withdrawal penalties
FAQs
What happens if there is an unexpected major expense I need to pay for?
You cannot pay for anything relating to the property out of your pocket and IRA contributions are limited and so there needs to be sufficient funds in your account that can cover unexpected events.
Who owns the property?
The title must be in the name of the custodian of the SDIRA for the benefit of the account holder. This means your account owns the property, not you.
I don’t want to manage a property, but I want to invest in real estate in an SDIRA account, what are my options?
There are a few options available to you use as REITs and crowdfunding apps such as fundrise.