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Using a Self-Directed IRA to Invest in Real Estate

One of the toughest hurdles for an investor to grow his real estate investments is raising capital. A self-directed IRA may be the answer. The term “self-directed IRA” actually refers to the administration of the IRA rather than the type of retirement account. A traditional IRA, Roth IRA, or SEP-IRA can be self-directed. The principle difference is, with a self-directed IRA, the account owner is in charge of the investment of the IRA funds beyond the limited choices offered by traditional custodians, such as banks and brokers. Those investment choices, with the right account setup, include real estate.

There are, however, some significant practical limitations to using a self-directed IRA to invest in real estate, so care should be taken before embarking on this approach. Here are the basics, along with some potential pitfalls.

Setting up a self-directed IRA

A typical IRA at a brokerage house or bank typically does not allow the flexibility of investing in real estate or other non-traditional assets for one reason. Their own institutional rules do not allow it. These accounts limit you to stock and bond mutual funds, certificates of deposit and similar investments. Now, some may still hear from bankers or brokers that using an IRA to invest in real estate is not permitted or “illegal”. We’ll give them the benefit of the doubt and say that they’re misinformed. Whatever the reason might be, they’re wrong.

So, to use an IRA to invest in real estate, you have to open an IRA with a company that is setup to handle real estate investments. There are several national companies that provide these “custodian” services for self-directed IRAs, such as The Entrust Group. We’re not going to offer an endorsement of any particular company, and there are many out there. I would suggest finding one that has been around for a good while and consulting with your legal or tax advisor and other real estate investors for recommendations.

Typically, administrative fees will be higher than the typical bank/broker custodians, but the whole purpose here is to use the IRA funds in higher return investments that, invested properly, will more than offset the cost differences. However, even among the self-directed custodian companies, the fees will vary significantly, so be prepared to shop around for the best deal.

How to fund a real estate investment with a self-directed IRA

The types of permissible real estate investments in a self-directed IRA are virtually unlimited. Commercial property, single-family homes, apartment buildings, and even the purchase of mortgages are all allowed. If your IRA buys a property for cash, the transaction presents little difficulty.

But there are some restrictions. We all know that an IRA owner can’t withdraw funds willy-nilly to pay for personal expenses. So, Mike couldn’t use his IRA funds to, say, pay for writing lessons. The reason is that, at their essence, tax regulation of IRAs, self-directed or otherwise, have a common theme–to treat (and to insure the investor treats) the IRA as separate from the owner. That concept carries through in the restrictions applicable to IRA purchases of real estate. So, the purchase transaction must be between your IRA (as distinguished from you) and an unrelated seller. That’s where the custodian comes in. The custodian, acting on behalf of the IRA and at your direction, will execute the purchase contract, as well as deed and other closing documents, on behalf of the IRA. So, other than that, you’re pretty much good to go.

Most of the potential pitfalls arise in structuring financing for real estate purchases where part of the purchase price is borrowed. Again following the concept of separating the you from the IRA, the mortgage loan to finance the purchase must be a “non-recourse loan,” meaning you can’t be personally obligated to repay the loan. So, mortgage funding will be more challenging. Commercial lenders do make non-recourse mortgage loans. But since they will have to look solely to the property’s income and value for repayment, the down payment requirements will likely be higher than an ordinary mortgage loan. You might also consider trying to find private lender funding or pooling your IRA’s funds with self-directed IRA’s owned by others in partnership, which, other than the prohibited transactions (relatives and such) is permitted under the regulations.

There are at least two other things to keep in mind when considering borrowing a portion of the purchase price:

  • You can’t pay the mortgage payment or expenses: Just as you cannot guarantee repayment, you cannot step in and pay the mortgage payment for the IRA or, for that matter, any other expense. Consequently, the IRA must have sufficient cash flow or assets to pay the mortgage and expenses. And no floating personal loans to the IRA to get it to payday either. Apart from ordinary contributions to the IRA, it’s on its own.
  • Unrelated business tax income (UBTI): The details of this tax are a little outside the scope of the article, but suffice it to say that Congress gets a bit out of sorts when a bunch of money’s lying around un-taxed. Suffice it to say that an income tax may apply to income generated from real estate investments in an IRA on the the portion of the investment funded through debt. With available deductions, this may or may not be a reason to stick with a cash buy, but on this front, I’d suggest you consult with your tax adviser.

Prohibited transactions

As I’ve alluded to, tax law restricts certain transactions with a self-directed IRA. Prohibited transactions include those between the IRA and a disqualified person. In rough cut, “disqualified person” includes the custodian of the account, relatives, and companies where the disqualified person has a substantial interest. In more IRS-like lingo, here is a more detailed laundry list of examples of prohibited transactions:

  • a transfer of plan income or assets to, or use of them by or for the benefit of, a disqualified person;
  • the sale, exchange, or lease of property between a plan and a disqualified person;
  • lending money or extending credit between a plan and a disqualified person; and
  • furnishing goods, services, or facilities between a plan and a disqualified person.

A disqualified person includes, among others, the following:

  1. a fiduciary of the plan;
  2. a person providing services to the plan;
  3. an employer, any of whose employees are covered by the plan;
  4. an employee organization, any of whose members are covered by
    the plan;
  5. any direct or indirect owner of 50% or more of any of the following:
  • the combined voting power of all classes of stock entitled to vote, or the total value of shares of all classes of stock of a corporation that is an employer or employee organization described in (3) or (4);
  • the capital interest or profits interest of a partnership that is an employer or employee organization described in (3) or (4); or
  • the beneficial interest of a trust or unincorporated enterprise that is an employer or an employee organization described in (3) or (4);
  1. a member of the family of any individual described in (1), (2), (3), or (4) (i.e., the individual’s spouse, ancestor, lineal descendant, or any
    spouse of a lineal descendant);
  2. a corporation, partnership, trust, or estate of which (or in which) any direct or indirect owner described in (1) through (5) holds 50% or
    more of any of the following:
  • the combined voting power of all classes of stock entitled to vote or the total value of shares of all classes of stock of a corporation;
  • the capital interest or profits interest of a partnership; or
  • the beneficial interest of a trust or estate;
  1. an officer, director (or an individual having powers or responsibilities similar to those of officers or directors), a 10% or more shareholder,
    or highly compensated employee (earning 10% or more of the yearly wages of an employer) of a person described in (3), (4), (5), or (7);
  2. a 10% or more (in capital or profits) partner or joint venture of a person described in (3), (4), (5), or (7); or
  3. any disqualified person, as described in (1) through (9) above, who is a disqualified person with respect to any plan to which a multiemployer plan trust is permitted to make payments under section 4223 of ERISA.

For most, what that list of disqualified persons means is that you can’t buy a rental property in Florida through a self-directed IRA and rent it to your parents. You also can’t buy a rental property near your child’s university and rent it to them.

Using the rental property for personal use may disqualify the entire self-directed IRA

Using a rental property for personal use may disqualify the entire self-directed IRA. So, assume you use $100,000 from a $1 million self-directed IRA to buy a condo at the beach. Even if you use the condo just two weeks a year, the entire $1 million IRA could be disqualified. Here’s how the IRS explains it:

However, in this case, with an individual retirement account, instead of imposing an excise tax on the parties to the transaction, the Code provides that the account is no longer an individual retirement account, and it is treated as if the assets were distributed on the first day of the taxable year in which the prohibited transaction occurred. (Code §408(e)(2))

The result would be a hefty tax bill and penalties. And that’s not good for anybody. So, as I noted at the start, a self-directed IRA can be a source of capital for investing in rental property. But the rules are complex, so you should seek the advice of a tax and self-directed IRA specialist before launching full bore. But here’s the thing. Like any investment strategy, there’s a certain learning curve. A good tax adviser can help you through the learning curve to help you see what’s possible in putting some of those real estate returns to work growing a retirement plan.

In the meantime, if you’d like to read more about using a self-directed IRA to invest in rental property, check out these books:

{ 22 comments… add one }

  • Diane December 17, 2007, 1:45 pm

    Millennium Trust Company http://www.mtrustcompany.com/services/ira/real.asp) located in Oak Brook, IL, custodies real estate in self directed IRAs. They are experienced, but don’t offer advice on the subject. They can educate you on the process. Try contacting Sandra Reese at sreese@mtrustcompany.com for more info.

  • Carl January 13, 2008, 12:51 pm

    My firm has a division that originates commercial mortgages and services them for private mortgage investors. I have been seeing more and more inquiries about our product from those with self directed IRAs.
    It makes sense. The investment is in a real estate instrument, better than average returns and it is totally arms length (which conforms to IRS rules on disqualified entities due to relationships).

  • Buying Tax Liens April 26, 2008, 3:46 am

    I didn’t realize this was even possible?

    But if I understand it correctly, I couldn’t take money out of my IRA, buy a house, and then lease it back to myself…or could I?

  • Self Directed IRA Advisor April 27, 2008, 12:58 am

    We help individuals self direct their retirement account with a truly self directed IRA.

    We are seeing an increase in the number of individuals who want absolute control of their IRA account. Although we help our clients get checkbook control over their retirement account, they still have to comply to the IRA rules and regulations. We help our clients rollover their current 401ks and IRAs, set up self directed IRA accounts, establish checkbook control, and help our clients navigate the mine field of costly prohibitive IRA transactions.

  • Katie Lawrence May 1, 2008, 10:19 am

    Buying Tax Liens:

    That is an excellent question that a lot of investors ask. I am the Public Relations Specialist at Guidant Financial Group, and in answer to your question: No, you cannot purchase a property with your IRA and then lease it back to yourself. The IRS has put strict regulations in place to prevent “self-dealing,” meaning, IRA account-holders benefiting from their IRA accounts before distribution.

    For more information on IRS “prohibited transactions” (i.e., what you cannot do with your IRA and its investments), see IRC § 4975(c) (1), or visit Guidant’s FAQs at: http://www.guidantfinancial.com/resources/faq.aspx

  • iravestordotorg October 19, 2008, 3:28 pm

    If your looking for more information on Self-Directed IRA’s please see IRAvestor.org http://www.iravestor.org IRAvestor is a free business directory for the Self-Directed IRA community.

  • John September 14, 2010, 2:19 pm

    I have 1st Trust Deeds in my self directed IRA. One of the TD’s I had to foreclose and ultimately took the property back and, in turn, turned it into a rental property. Can I write off my expenses via Schedule E?

  • Sid Callahan March 8, 2011, 10:02 am

    Can I hold a 70-80% first morgage ( my son and wife) in my rollover IRA?? Any restrictions?

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      Without debt in America we wouldn’t have cuercnry. The way our money is created is out of thin air and recreated over and over based on a flawed reserve system. I love precious metals.Gold is a great way to hedge against inflation, not necessarily as an investment with real growth potential. Just look at the drop it has taken over the past month. Gold always holds its value against inflation. An ounce of gold today buys a good men’s suit just as it did in 1920, 1940, 1950, 1960, 1970, 1980, 1990, 2000 and 2010. Just check the price history of gold. Real estate used to be similar, holding it’s value against inflation. But the trends in lending, speculation and government interference have caused real estate to lose value against inflation. Self directed IRA’s are great and really do enable the individual investor to chart his or her own course. Wouldn’t be surprised if the Fed’s stop this form of IRA. Wouldn’t want the masses to make their own decisions now would we?

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