What Is a Real Estate IRA?

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Real estate can be an excellent growth vehicle for long-term investors. After all, real estate is relatively low risk and capable of producing substantial gains over time—especially when combined with tax-friendly individual retirement accounts (IRAs).

In this post, we’ll explore what real estate IRAs are all about and show you how to add property investments to your IRA portfolio.

Real estate IRAs: An Overview 

Most IRAs have limitations in place governing the types of assets that investors can keep in their accounts. For example, traditional IRA investments include stocks, bonds, mutual funds, and exchange-traded funds (ETFs). 

For the record, when you hear the term “real estate IRA,” people are referring to a self directed IRA (SDIRA), which enables investments in a more diverse array of assets (e.g., tax lien certificates, precious metals, and real estate). IRA stands for “individual retirement account.

Most importantly, SDIRAs enable you to invest in real estate opportunities, including raw land, office buildings, retail shops, hotels, and even farms.

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Why most investors don’t have real estate IRAs

Some of you may be scratching your head, wondering, “how is this legal?” The answer is simple.

For starters, the IRS allows an IRA owner to include real estate investments within their IRA. Most people don’t do this simply out of ignorance: they don’t know real estate is a viable investment option.

Typically, your financial institution decides which types of assets you are allowed to invest in. Since banks don’t offer alternative investments like real estate, it’s usually not available within most retirement plans. 

With that said, you will have to look beyond the traditional IRA provider to explore real estate investment opportunities. 

How SDIRAs work 

Investing in SDIRAs requires using a passive third-party agent who serves as an IRA custodian or trustee and specializes in nontraditional investments.

First, find a property or nontraded business in which you want to invest. Then, go through the same buying process you would normally. The main difference is your specialized SDIRA custodian handles the transaction instead of a traditional IRA custodian (e.g., Schwab or Vanguard).

Can you take out a loan using an SDIRA?

One common misconception about real estate IRAs is that you need to have the full purchase amount in the SDIRA to directly purchase a property.

As it turns out, this isn’t the case. It’s possible to use the SDIRA to take out a non-recourse loan and finance larger purchases.

A non-recourse loan is a type of secured loan backed by collateral. Usually, the collateral is the SDIRA account holder’s equity of the financed property. 

An interesting fact about non-recourse loans through an SDIRA: In the event of a default, the lender can only seize the IRA account holder’s linked investment property for repayment.

This means that the lender can’t claim the IRA owner’s other assets because the loan is only backed by the property. This is different from how traditional loans operate (e.g., mortgages), wherein a lender can seize a borrower’s other assets in the event of a default.

Transferring a SDIRA

An easy way to fund your SDIRA from the get-go is to rollover funds from a traditional IRA or Roth IRA. 

For example, if you already have $50,000 in IRA funds elsewhere, you can quickly take half of that out to make a real estate purchase. All you have to do is open an SDIRA, transfer money into that account, and move forward with the transaction. 

Otherwise, SDIRAs are subject to the same contribution limits as traditional and Roth IRAs: $6,000 per year if you are under age 50, and $7,000 per year if you’re older.

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The pros and cons of real estate IRAs

There are some important things to consider before using an SDIRA for real estate. Here are the pros and cons.

Advantages 

Tax-friendly growth

If executed properly, buying real estate through an SDIRA could produce a steady cash flow—especially if you invest in lucrative commercial real estate like an office building or storefront. 

On top of that, the money could grow on a tax-free or tax-deferred basis, and you won’t have to pay the tax immediately on capital gains. 

The combination of tax advantages and the potential for steady cash flow could set you up for long-term financial success. However, make sure to consult with a qualified tax advisor to ensure everything you’re doing complies with the IRS.

Bankruptcy protection

Not all investments work out, and sometimes filing bankruptcy is necessary. Should this happen, investors are protected through the Bankruptcy Abuse Prevention and Consumer Act. This allows investors to protect up to $1 million of SDIRA funds from lenders. Additional protections may also be available from state governments. 

Diversity 

Another attractive aspect of an SDIRA is that you don’t have to limit your portfolio to a real estate asset. You can also invest in stocks, bonds, and certificates of deposit (CDs), to name a few. Taking this route can increase portfolio diversity, reducing risk and exposing you to different markets. 

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Disadvantages 

Contribution limits

Just like a traditional or Roth IRA, SDIRAs come with annual contribution limits ($6,000 annually for 2021, and $7,000 for people over the age of 50). There are no income limits, so that’s good news.

Due to these contribution limits, unless you have a bunch of money in another IRA you can rollover, you may have to wait a few years to build up enough capital to buy an expensive property. Alternatively, you can look into taking out a non-recourse loan. 

Heavy regulations

One of the downsides to using an SDIRA for real estate is that it’s heavily regulated, and you have to be very careful to follow all the rules. Otherwise, the IRS might consider you a disqualified person.

For this reason, it’s critical to work with a self-directed IRA custodian who knows what they are doing with your IRA money so you don’t make any major errors. Simply put, this investment avenue is far more complicated than dealing with other types of accounts.

Market volatility 

SDIRAs can’t shield you from market volatility. Investing in real estate as a retirement vehicle can be risky, as property values and market conditions can change over time. 

If you’re considering going heavy on real estate, be sure to thoroughly vet the properties you choose and stay on top of changing markets to avoid losing money. This is even more important if you’re considering taking out a non-recourse loan to fund your real estate transaction.

Fees

Another downside to SDIRAs is that they come with custodian fees. You can expect to pay anywhere from $200 to $2,000 or more for this type of account. As such, it pays to shop around to find an expert in this field who charges a reasonable rate.

Not for personal use

This part is important: If you buy real estate through an SDIRA, it can’t be for personal use or funding your vacation home. It has to be purely for investment purposes. 

Buying a property through an SDIRA and attempting to occupy it could result in serious penalties and disqualify your account. This is for investing only.

Accessibility 

Perhaps the biggest downside to investing in an SDIRA is that you can’t access the funds until you reach retirement age.

This can be frustrating if you become successful and reach millionaire status. As such, it’s a good idea to also invest in real estate outside of your SDIRA, either by buying properties using non-retirement money or through a brokerage account with REITs. Otherwise, you’ll likely have to wait decades before you can access any returns.

Frequently asked questions

What is a prohibited transaction?

Just because you open an SDIRA doesn’t mean you can go hog wild and start investing in whatever you want. There are some restrictions to follow, which the IRS calls a prohibited transaction.

For example, you can’t invest in items like gems, artwork, or stamps. Make sure to check the rules before you set one up to avoid any potential complications. This is something your custodian should be able to help with.

Do real estate IRAs really exist?

Technically speaking, there is no such thing as a real estate IRA. Rather, this is a term people use to describe making real estate investments through a self-directed IRA (SDIRA). 

In order to create your own real estate IRA, you first have to set up an SDIRA through a third-party provider and hire a custodian to manage it. 

The SDIRA can also contain other types of investments like stocks, bonds, index funds, mutual funds, or ETFs. So, it’s not exclusively for real estate, but it can contain real estate.

Is real estate investing risky?

All investing is risky, and real estate is no exception. Granted, real estate is less risky than some other forms of investing like stocks or cryptocurrency. However, markets can change, and prices can fluctuate. So there’s no guarantee you’ll generate a strong return on investment when buying real estate.

Before making any investment decisions, make sure to check your overall portfolio and determine how much risk you can comfortably handle. You may not be in a position to buy real estate. Or, you could be in a great position, depending on the amount and diversification of your other retirement funds.

What is an investment property?

An investment property is typically a rental property that produces rental income. Investment properties can also include commercial properties, office buildings, and retail chains. 

The IRS makes it very clear that you can’t personally live in a real estate investment property funded through an SDIRA. 

If you want to buy real estate for you and your family to live in—as you should!—you will need to secure traditional funding for the purchase. Liquidating your IRA account’s earnings to pay for a personal home may lead to tax penalties.   

The Bottom Line

Investing in real estate through an SDIRA could be a great personal finance decision. Serious real estate investors should strongly consider exploring this path because the tax benefits alone make this strategy very appealing.

To be clear, this investment vehicle can also be risky. So, as with any investment, make sure to do your due diligence and only trust a provider with a stellar reputation and a proven track record.

Here’s to finding wealth-growing opportunities and following through with them so you can retire early and not worry about making ends meet.

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