Nearly 65% of Americans are homeowners, and far fewer own real estate investments.
Yet, real estate as an investment is typically stable and can help you diversify your portfolio. Plus, there are ways to invest in real estate without taking out a mortgage.
Using your IRA to invest in real estate is one way.
In this article, you’ll learn everything there is to know about buying real estate with an IRA. Let’s get started.
What Is an IRA?
An individual retirement account (IRA) is a savings account with tax advantages. Individuals can open an IRA account to invest and grow retirement savings long-term.
It’s similar to a 401(k) account that an employee receives as a benefit from their employer.
Anyone who earns an income can open an IRA account through a:
- Investment company
- Online brokerage
- Personal broker
While there are several different IRAs, the two most common are traditional and Roth. A traditional IRA is a tax-deferred account that uses pre-tax dollars. That means you can deduct your contributions from your income tax each year.
This lowers your tax responsibility in your working years. The IRS will tax you on the money when you withdraw it in retirement.
Conversely, a Roth IRA uses post-tax dollars. That means your contributions are not tax-deductible. Instead, you pay income tax on the contributions upfront. But, your investments grow tax-free.
When you withdraw money in retirement, you don’t pay taxes on your contributions or profits.
It’s possible to use your IRA money to invest in real estate. After all, real estate is an investment like other securities such as stocks, bonds, and mutual funds. But, most brokerage accounts don’t allow you to invest in real estate with your IRA.
So you’ll need a self-directed IRA.
What Is a Self-Directed IRA?
A self-directed IRA allows for alternative investments. For example, you can invest in cryptocurrencies, real estate, precious metals, oil, and more with this account.
It’s independent of any brokerage, bank, or investment company that would make decisions on your behalf.
But, you need an IRA custodian for your account. A custodian is an entity that handles self-directed accounts. The custodian manages:
- Financial reporting
A custodian is necessary to adhere to the strict rules of IRA real estate transactions.
You can choose your self-directed IRA to be traditional or Roth, depending on your preferences and long-term goals. Those eligible can also opt for a SEP-IRA, SIMPLE IRA, or solo 401(k).
For example, if you want your property investments to grow tax-free, opening a self-directed Roth IRA for real estate investing is a wise choice.
But, it would be best if you spoke with an investment professional to help you choose the proper IRA account for you.
Rules for Buying Real Estate With an IRA
It’s crucial to remember that when you buy real estate with your IRA, your account owns the property, not you.
If you incorrectly buy real estate with your IRA, it could disqualify the account. If the account becomes disqualified, all your funds become taxable. This can be a costly mistake to make.
Thus, there are some rules you must follow.
The most important rule is that real estate must be for investment purposes only. You can buy a variety of property types, such as:
- Single-family rental
- Multi-family rental
- Commercial building
- Undeveloped land
But, not you or any of your family can ever use the property for personal reasons. For instance, if you rent out a vacation home, you can never stay there, even when it’s vacant.
You also can’t buy property from yourself or a family member as a way to access your IRA money early. This is a self-dealing transaction, and it will make the IRA disqualified.
You must not receive any indirect benefit either. This means you can’t hire yourself or a family member to be the property manager. You should always be distant from the investment.
Further, you must pay all property costs out of the IRA and deposit all income into the IRA. The rule applies to more than monetary expenses. For example, you can’t use previously owned furniture in the property.
If you have a large expense and not enough money in your IRA, you could be in a troubling situation. While you can put more money in your IRA, this isn’t a viable strategy.
The IRS limits how much you can contribute to an IRA account each year.
Additionally, you can’t work on the property. You must always hire an independent person to do repairs.
Getting a Mortgage With Your IRA
The last rule relates to getting a mortgage for the investment property when you pay with your IRA.
Technically, you can’t get a mortgage for the property. This is because your IRA owns the property, not you. However, your IRA can take out a mortgage, but you need to find a lender willing to loan money to your IRA account.
These lenders exist. They offer non-recourse loans. This means the lender cannot go after any assets aside from the property if you stop making payments. So your personal finances and other investments are safe.
The lender takes on much more risk with a non-recourse loan. So these loans require a higher down payment than a typical investment property mortgage. Most will require a 40-50% minimum down payment.
These loans also come with higher interest rates.
Using Leverage To Secure Financing
If you don’t have enough money in your IRA to pay cash and you don’t want to take out a mortgage, you can also consider using leverage.
Leverage comes with its own risks, but it can multiply your return. Investors put down a small amount and take advantage of low-interest rates to leverage the purchase.
This means they think they will make more money on the property than they’ll need to pay in interest.
However, the IRS can consider any revenue from the property as unrelated business taxable income (UBTI). UBTI is regular income from a tax-exempt entity through taxable activities.
In this case, the tax-exempt entity is your IRA, and the taxable activity is buying real estate.
If your IRA makes a debt-financed purchase, you will become susceptible to paying UBTI taxes.
The Pros and Cons of Buying Real Estate With an IRA
The tax benefits of an IRA apply no matter what type of investment the IRA owns. Since real estate can generate excellent long-term returns (of more than 10%), it’s a great way to multiply your money more without a tax burden.
You can reinvest your rental income without paying tax, and you can avoid capital gains tax when you sell the property.
Plus, real estate is more recession-resistant than other investments and securities. Property values don’t fluctuate as much. And during difficult economic times, people still need a place to live. So rental occupancy remains steady.
On the other hand, the IRS doesn’t allow you to claim deductions, depreciation, or a loss in your IRA. A significant benefit of investing in real estate is depreciation. This could hurt you financially.
As discussed, the IRS limits how much money you can add to your IRA each year. So it can take years to build up enough cash to buy a property using that money. As a result, you often need to transfer a large existing IRA balance to a self-directed IRA.
With a self-directed account, you take full responsibility for your investments. You won’t receive advice or guidance from your custodian.
Further, you cannot withdraw from your IRA until age 59 1/2 (unless under specific circumstances), and for a traditional IRA, you must begin withdrawing the minimum distribution once you reach age 70 1/2.
Real estate is much harder to sell off than other securities making it illiquid. These requirements can hinder how much you benefit from the investment.
Of course, the biggest downside of buying real estate with your IRA is mistakenly breaking the rules. If this happens, you will face severe tax penalties.
Other Real Estate Investment Options With an IRA
Buying property isn’t the only way to invest in real estate with an IRA. You can also use a real estate syndication. A syndicate is a group of investors who pool their money to invest in larger properties.
You decide where to invest your money, but you don’t need to find tenants or be involved with maintaining the property. If you’re an accredited investor, a syndicate is a smart choice for you.
Another option is to buy shares in real estate investment trusts (REITs). These are companies that own or finance real estate. You can purchase REITs on the stock market, making it an easier investment, especially when you use your IRA.
Even some emerging online platforms allow you to invest in real estate with your IRA. One example is Poltify. It operates similar to a syndicate but without tight restrictions on who can invest.
Learn More About Investing
Buying real estate is one way to invest the funds of your IRA account. But remember, you’ll need to open a self-directed IRA account, hire a custodian, and strictly follow the IRS guidelines.
If you want to learn more about investing, speak with a qualified financial planner or investor to guide you through the process.
You can also head over to the Finance section to find more articles about investing and retirement. We add new content regularly for you to explore.
Tax Free Retirement Account (TFRA): What Is It and How Does It Work?
Commercial Real Estate Investing: How to Get Started
Commercial Real Estate Financing Basics
Roth IRA Conversion: Pros and Cons