Rules, Risks, Pros & Cons

• Buying real estate with an IRA is a way you can diversify your investment portfolio.
• This type of investment requires a self-directed IRA, and you can’t live in the property.
• Purchasing REITs is a simpler way to gain real estate exposure in your IRA, with fewer risks.
• Read more stories from Personal Finance Insider.

Individual retirement arrangements (IRAs) are among the best ways to save for retirement. They offer significant tax advantages and flexibility and can be an alternative or a supplement to an employer-sponsored retirement plan like a 401(k).

While most people probably think of securities like stocks, bonds, and mutual funds when considering an IRA, you can also use them to invest in other assets, including real estate. Though there are quite a few legal hurdles to consider — and a specific type of IRA that you must use — here’s how that works.

4 steps to buying real estate with an IRA

1. Find an IRA that you can use to buy investment properties

First of all, in order to buy real estate with an IRA, you need a

self-directed IRA

(SDIRA). IRAs in general are more flexible in terms of the types of investments you can hold in them, compared with 401(k)s or similar retirement accounts. 

Not all brokerages offer SDIRAs. You can search online for “SDIRA custodian” or “SDIRA provider” to locate one. A few providers of self-directed IRAs include Charles Schwab, Equity Trust, uDirect IRA, and Alto IRA. Do some comparison research to find a provider with experience and value. (Checking ratings with the Better Business Bureau is a good place to start.) 

Self-directed IRAs have the same basic rules and restrictions as regular IRAs and provide the same benefits of either tax-free or tax-deferred growth.

Contribution limits are $6,000 annually for IRAs in 2022, unless you’re 50 or older, which is when your maximum increases to $7,000. If your current IRA isn’t self-directed, you can roll the funds over to a self-directed IRA.

While many alternative investments are permitted in your self-directed IRA, there are some prohibitions. These include things such as collectibles and life insurance, according to the Internal Revenue Service. Collectibles include items such as stamps, gems, artwork, antiques, alcohol, and coins or metals (with some exceptions for coins and metals).

Other alternative assets you can often invest in using your self-directed IRA include promissory notes, private placement securities, tax lien certificates, and cryptocurrencies.

2. Select someone to administer the account

Your self-directed IRA will need to have an appointed custodian to handle the paperwork and administrative tasks.

Part of the appeal of self-directed IRAs is their broader range of investment options. Compared with other retirement accounts like managed IRAs or 401(k)s, a self-directed IRA allows a lot of flexibility. 

The downside of that freedom is that you don’t receive the same level of investor protections. The custodians for self-directed IRAs leave most research duties to you, the owner. In other words, the custodian won’t perform due diligence to help you avoid fraudulent or volatile investments. 

The Securities and Exchange Commission (SEC) warns that custodians of self-directed IRAs only have “limited duties to investigate the assets or the background” of someone promoting an investment to customers. 

The SEC recommends that you always verify information in your SDIRA account statements, avoid unsolicited offers for investments, doubt any claims of guaranteed returns, and consult a professional like an attorney or licensed investment professional about investments in this IRA.

3. Find a property that qualifies for purchase with your IRA

If you’re serious about buying a property with your IRA, familiarize yourself with some key guidelines. Otherwise you could face fines and penalties. 

All types of real estate qualify for purchase in an IRA, including:

• Residential (condos, single or multi-family homes, apartments)
• Commercial (storage units, office buildings, factories)
• Raw land 

Asher Rogovy, chief investment officer of Magnifina LLC, suggests that a multi-unit property may be more suitable as an investment than a small one. “More rental income helps amortize custodial fees,” Rogovy says.

As long as you follow the guidelines regarding personal use and funding, any of these kinds of real estate should be permitted. Remember:

• You cannot occupy the home or property in any way or for any amount of time. It can’t be your primary residence, vacation home, or business property. 
• Nobody who is related to you may rent the property purchased with an self-directed IRA. Disqualified persons include your spouse, parents, grandparents, great-grandparents, children and their spouses, and grandchildren and their spouses.
• Once you’ve purchased property, you can’t perform any of the maintenance or repairs yourself. You must use funds from the SDIRA to pay contractors to do any required work. 

Since it’s uncommon to take out a loan for a property you’re buying with your SDIRA, that will limit the price you can pay. Be sure to also factor in the recurring custodial fees for the self-directed IRA as well as a buffer of extra funds for property improvements. 

If you’re caught having done the work on your IRA-owned property, you’ve broken the rules and will face significant tax penalties as a consequence. 

Under the law, doing your own upgrades counts as a “disqualified self-dealing transaction” and then the IRA is treated “as if it has distributed the entire fair market value of the property as a taxable distribution,” cautions Warren Ward, a CFP® professional and financial advisor at WWA Planning and Investments.

4. Purchase the property through the IRA

Once you’ve selected a provider and a custodian and set up your SDIRA, you can find your property. Just make sure it fits your criteria and you can follow all IRS rules. 

If you don’t have enough money in the IRA to buy a property in full, you might wonder about a mortgage. However, mortgages are fairly rare when using an IRA to fund a purchase.

“It’s unlikely that anyone would make a loan to purchase property inside an IRA because such assets are protected from creditors in bankruptcy,” Ward says. He also notes that if you find a friend or relative willing to make that loan, 39.6% in taxes would be owed on rental or sale income from the leveraged amount. You’d need a Form 990-T to report unrelated business income.

Expect to complete a large amount of paperwork, even more so than with traditional real estate transactions.

Is using an IRA to invest in real estate right for you?

When investing in real estate, doing so through your IRA isn’t necessarily the best route. Consider the pros and cons as they relate to your circumstances. 

Benefits of buying real estate with an IRA

• You get either tax-deferred or tax-free earnings, depending on whether it’s in a Roth or traditional IRA. Real estate can bring high rates of return. 
• You won’t incur any expenses out-of-pocket to maintain or manage the property. This is a benefit as long as you always have sufficient funds within the IRA to cover unexpected and costly repairs or updates. If you consider your IRA a completely separate bucket from your other financial accounts, it won’t affect your current budget.
• The property is owned by the IRA, so all rental income will funnel directly back into the IRA, giving you a tax advantage. With other real estate investments, you’d be subject to income tax on rental payments during that year.
• If you don’t need the rental income in the short term, that money will go back into the IRA where it can grow. Plus, you can continue annual contributions to keep the account funded. 

Remember another top reason you may want to invest in property through an IRA: It’s a diversification strategy. Rather than keeping all of your investments in a single asset type like stocks and bonds, real estate can lower your risk in times when the overall market is in a downturn. 

Potential drawbacks of buying real estate with an IRA

• Buying real estate with an IRA is generally more of a hassle than other investments. There’s a lot more and steps to complete than there would be for buying securities like stocks, bonds, and mutual funds.
• It puts a lot of pressure on you to protect yourself. The flip side of more freedom to dive into alternative assets is heightened risk. Your custodian only handles administrative work and isn’t obligated to vet real estate or any other investment.
• Amassing enough money to buy property outright can be difficult, and borrowing isn’t usually an option. Along with the cost of purchasing the property, your account must also have enough money in it to cover ongoing expenses.
• There can be substantial penalties for breaking the rules, even if accidentally. The property can only serve as an investment vehicle. “Consult a tax professional if you hold IRA real estate and want to make some changes that won’t put you in legal jeopardy or risk of hefty fines,” David Aylor, founder and chief executive officer of Aylor Law Offices.

Also keep in mind that if you own real estate through an IRA, you won’t be able to claim tax deductions on it. You can’t deduct for mortgage interest, property taxes, or a range of other items as you can with your home or other real estate investments.

Real estate “comes with a lot of expenses that you wouldn’t ever encounter with traditional investments,” says Jim Pendergast, senior vice president of altLine at The Southern Bank Company. “You don’t have to pay property taxes or maintenance on ETFs and mutual funds.” 

Alternatives to buying real estate with an IRA

If you’re set on investing in real estate, but aren’t quite convinced an IRA is the best vehicle, consider these alternatives. 

As the CFA Institute notes, investing in real estate in a pooled manner can be a better option, especially for smaller investors. You can more easily invest in real estate investment trusts (REITs) or mortgage-backed securities (MBS) through your IRA than you can buy a private investment property. 

Magnifina’s Rogovoy says: “If an investor is simply seeking exposure to a real estate market in an IRA, using a

REIT

can be considerably easier. There are plenty of exchange-listed REITs that offer exposure to specific kinds of real estate.”

The fairly high risk involved in buying real estate with an IRA could lead you elsewhere. You can diversify your portfolio and gain exposure to real estate through REITs, which require little maintenance and are less risky.

As Ward notes, buying real estate through your IRA can be “fraught with potential land mines for the user.” If you do decide to use an IRA to finance the investment, diligence in following IRS guidelines is key to making it a smooth process.

Kate Underwood

Kate Underwood