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How to Use a Self-Directed IRA to Invest in Real Estate

joint study by several U.S. and German universities and the German central bank analyzed 145 years’ worth of returns on different asset classes. They found over that long time horizon, rental properties offered the highest returns.

Yet those high returns didn’t come with the highest risk — rental properties saw far less volatility than stocks.

Although it comes as no surprise to experienced real estate investors, it does raise a question. If you like real estate as an asset class, how can you invest in it using a tax-sheltered retirement account?

Enter: the self-directed IRA.

What Is a Self-Directed IRA?

Investors hold their “normal” IRAs at investment brokerages.

These standard individual retirement accounts let you buy and sell paper assets such as stocks, bonds, exchange-traded funds (ETFs), mutual funds, and real estate investment trusts (REITs), just like any other brokerage account.

Which is to say, they only let you buy publicly traded paper assets.

As an alternative, investors can open a self-directed IRA (SDIRA), where they can invest in almost anything they want. Top of the list for most investors: real estate.

Like regular IRAs, investors can open an SDIRA as a traditional or Roth account.

However, SDIRAs come with their own restrictions and drawbacks. First, investors must pay a third-party IRA custodian to oversee the assets on their behalf. That adds not only costs but administrative headaches because you must coordinate with your custodian to invest.

Some investments are prohibited in SDIRAs as well. These include primary residences, life insurance, some types of derivatives, collectibles and antiques, and certain types of coins.

Leverage and financing get tricky with SDIRAs. If you use a loan to buy an investment property, you only get the IRA tax advantages proportional to your down payment. That makes for complex accounting and limited upside.

Read up on the other advantages, disadvantages, and rules associated with self-directed IRAs before going through the trouble of hiring a custodian and opening one.

The Easiest Way to Invest in Real Estate With an SDIRA

Yes, you can use SDIRAs to invest directly in brick-and-mortar real estate (more on that shortly). But that layers on some complications, as noted above.

IRA account holders do have a middle-ground option, however. You can open an SDIRA to hold privately traded REITs and other real estate crowdfunding investments.

By doing so, you skip many of the headaches normally associated with SDIRAs. But you still get to invest in real estate indirectly using a tax-deferred retirement account.

In particular, Fundrise makes this extremely easy. They partnered with Millennium Trust Company as an SDIRA custodian, which charges a flat fee of $125 per year. You can still manage all your Fundrise investments through the Fundrise platform.

Fundrise offers a range of private REITs that blend both direct real estate investments (such as apartment buildings) with loans secured against real estate. You can choose more income-oriented REITs or more long-term appreciation-oriented REITs, or a mix of investments.

You can also use Millennium Trust Company as a custodian to hold other real estate crowdfunding investments in your SDIRA. Easy options include Streitwise, Diversyfund, and GroundFloor.

For that matter, you can use Millennium Trust Company as an SDIRA custodian for traditional investment assets such as stocks, bonds, and publicly traded REITs, in addition to more alternative investments like hedge funds, private equity, physical precious metals, cryptocurrency, and real estate holdings.

Public vs. Private REITs

Investors can indirectly invest in real estate with a traditional IRA by investing in publicly traded REITs. So why bother hassling with self-directed IRAs to invest in private REITs?

Publicly traded real estate investment trusts come with some significant downsides.

To begin with, because they trade on stock exchanges, they tend to move with far more correlation to stocks than actual real estate prices do. That defeats much of the purpose of diversifying your assets into real estate.

Plus, because they trade on public stock exchanges, they come with the same liquidity as stocks. Liquidity is a sword that cuts both ways: the instant ability to buy and sell leads to volatility. And if there’s ever a place where working-age investors don’t need liquidity, it’s in their retirement accounts.

Also, the U.S. Securities and Exchange Commission (SEC) regulates publicly traded REITs differently than crowdfunded investments.

The SEC requires publicly traded REITs to pay out at least 90% of their profits to shareholders in the form of dividends. That makes it nearly impossible for them to put their profits toward buying new properties and growing their portfolio, which in turn limits appreciation and growth potential.

Although publicly traded REITs aren’t an inherently better or worse way to invest in real estate than crowdfunding investments, they are different and come with their own pros and cons.

Other Ways to Use an SDIRA to Invest in Real Estate

While it’s certainly easier to use an SDIRA to buy real estate crowdfunding investments than physical real estate, that doesn’t mean you can’t or shouldn’t buy the “real” thing.

You can even use the same custodian that Fundrise partnered with, Millennium Trust Company, to buy brick-and-mortar real estate investments in your SDIRA.

Before going any further, note a few basic ground rules.

The IRS imposes rules against self-dealing. You can’t buy a property from yourself to transfer to an SDIRA, nor can you buy from a “disqualified person,” such as an immediate family member. These count as prohibited transactions.

You also can’t gain any “indirect benefits” from investments held by your SDIRA, such as moving into the carriage house on your rental property.

Rental Properties

Rental properties come with some wrinkles when it comes to investing with an SDIRA.

But rentals also combine ongoing passive income with inflation protection and a great track record for appreciation — a winning combination for long-term retirement investments.

As mentioned above, if you finance a rental property bought using an SDIRA, you only get the IRA tax benefits for the portion you paid for with cash.

Buy a $150,000 rental property with a $30,000 down payment (20%) and a $120,000 mortgage, and only 20% of the property’s profits get tax benefits.

Which says nothing of the extra headaches of working with your SDIRA custodian, your mortgage lender, and your accountant.

You could buy in cash, but even if you have the cash handy, that doesn’t mean you can contribute enough of it to your SDIRA to buy a property.

In tax year 2021, the IRS only allows you to contribute $6,000 ($7,000 if you’re over 50). I’ve bought some dangerously low-end properties in my career, but never any that cost that little. It would take years of maxing out your contributions to save enough to buy a typical rental property in cash.

One possible path involves investing in a conventional IRA for a few years, maxing out contributions and allowing returns to start compounding. When you have enough for a down payment, or to buy a property outright, you can then roll over your funds to an SDIRA.

Consider a Roth SDIRA if you plan to buy rental properties, to take maximum advantage of the compounded rents and appreciation over the coming decades.

Speaking of rental income, income payments you receive must stay in the SDIRA until you’re 59 ½. You can cover expenses such as property taxes, insurance, maintenance, and repairs with them, but you can’t touch the profits. To do so constitutes a taxable withdrawal or distribution.

Instead, reinvest them toward other investments to enjoy the compounding.

Flipping Houses

All the same complications apply to flipping houses with an SDIRA. Plus a few fresh ones for good measure.

You have to keep some distance from the project if you buy a fixer-upper to flip with an SDIRA. The IRS doesn’t allow you to engage in regular business activity as part of a tax-free retirement investment. Otherwise, you risk owing Unrelated Business Income Tax (UBIT), which would defeat the entire purpose of investing through an SDIRA.

That means you can’t run a flipping business through your SDIRA, banging out a dozen deals a year, even if you have the funds in your SDIRA to do so. It smacks of a business, rather than a passive investment on the side.

You also can’t “add value” to the deal through your own actions. That includes doing any of the renovation work yourself. You can, however, oversee the project as an arms-length manager.

If that sounds like a fine line to walk, it is.

You can likely flip two or three houses per year with your SDIRA while staying neatly within IRS guidelines. But what about five? Ten? At a certain point, the line gets blurry and you start inviting unwanted attention from Uncle Sam.

House flipping can make an excellent strategy for compounding your Roth IRA funds quickly. In the beginning, you could finance much of the purchase and renovation with a hard money loan, and then start buying with only your SDIRA funds as you accrue profits.

But speak with an SDIRA custodian who specializes in working with real estate investors before you move forward to talk through all the complications and restrictions.

Other Real Estate Investment Options

The sky’s the limit in using an SDIRA for real estate investing. You can buy raw land, or trailer parks, or commercial real estate, or any other property investment.

The mechanics of it are simple in theory.

You create an LLC or other legal entity, and you direct your custodian to “invest” your money in that LLC. You then make real estate purchases under the LLC name, whether that’s a single-family home to flip, a commercial property, or any other investment. As the signer on the LLC’s bank account, you theoretically control the money.

In practice, the custodian has to sign off on your investment decisions and reviews your books and activities to make sure you aren’t violating the (complex) laws governing self-directed IRA investments.

Talk to an expert before you proceed, so you don’t get caught flat-footed by the rules and regulations.

Final Word

I firmly believe every investor should have stocks in their portfolio regardless of their prowess investing in other asset classes. As a real estate investor myself, I’m keenly aware of real estate’s pros and cons, and how well stocks complement it.

Consider using conventional IRAs to hold your stocks and other paper assets. You have plenty of other ways to lower your taxes as a real estate investor, given real estate’s inherent tax advantages.

Skip the complex regulation, the custodian hassles, and the costly fees. Use your IRA to diversify your stock holdings and let them compound. Invest in real estate to generate income and profits you can use today — and keep reinvesting for ever-greater income.

G. Brian Davis is a real estate investor, personal finance writer, and travel addict mildly obsessed with FIRE. He spends nine months of the year in Abu Dhabi, and splits the rest of the year between his hometown of Baltimore and traveling the world.

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