Let’s imagine you want to invest in real estate. Maybe you want to purchase a new rental property to start earning additional income, but you don’t have cash on hand and you don’t want to take out a loan from the bank. What other options are there? One option is to use funds in your IRA, although there are many rules to keep in mind if you want to consider this.
- In order to use funds in an IRA to invest in real estate it must be a Self-Directed IRA or SDIRA. These are IRAs were the investment choices are handled by the IRA owner and not by any third party. Although the custodian will handle the backend buying and selling to comply with all rules and regulations, it would be up to you to decide what and when to buy and sell. Additionally, a main function of SDIRAS is to offer more investment options such as real estate that are not available in a regular traditional IRA.
- SDIRAs are a specialized account and as such, require you to use a custodian that specializes in these accounts. For example, the custodians that we use, Morgan Stanley and Charles Schwab, do not specialize in SDIRAs.
- There are certain restrictions on which transactions are allowed. When purchasing real estate through your SDIRA, the property must be used only for investment purposes. It cannot in any capacity be used for personal reasons by you or anyone the IRS deems as a “disqualified person”. Examples of people in this category are:
- Your spouse
- Your parents, grandparents, and great-grandparents
- Your children and their spouses, grandchildren, and great-grandchildren
- Service providers of your SDIRA
- Any entity that owns more than 50% of the property
- When you purchase real estate through a SDIRA, the property is owned by the SDIRA and not by you directly. The significance of this is that any expenses or income generated by this investment property must flow in and out from the IRA directly. For example, maintenance expenses and taxes must be paid out from the SDIRA balance, and rental income must be paid back into the SDIRA. These funds will not be available immediately if you do not already meet the requirements to withdraw from your SDIRA without penalty. You should be cautious of potentially draining the SDIRA balance if there is not enough spare funds to cover all necessary expenses. When purchasing the property, it is typically paid for in cash from the SDIRA, and when the property is sold, all proceeds will be deposited back into the SDIRA.
- As the SDIRA funds are tax deferred, you are not allowed to take any tax deductions typical of owning rental properties on your return. You can’t claim deductions for property taxes, mortgage interest, depreciation, and other property-related expenses.
- Can you use a SDIRA to provide a mortgage?
- Yes you can provide mortgages this way, however, like with real estate, the person on the other end cannot be a disqualified person. Additionally, it must follow the normal rules for providing private personal mortgages. Mainly that you do not have complete freedom over the terms of the loan. It must be similar to the loans someone could get from a bank.
- Keep in mind that there are various risks to consider:
- One of the biggest risks is that if you fail to follow the above rules the entire IRA can be disqualified making all funds and transactions taxable.
- Depending on the price of the property and total balance of your account, you should be cautious of your overall diversification.
- Depending on your age, RMD’s need to be a consideration. Real estate is an illiquid investment and the property would need to be appraised annually to determine the RMD amount.
- These are just a number of risks associated with this investment. Careful consideration of your own individual situation should be taken into account with regard to the potential benefits and risks involved.
Generally speaking this is not a common investment choice and will not be a good fit for every investor. This blog is not intended to be investment, tax, or legal advice. If you would like to consider this type of investment, I would encourage you to reach out to a financial advisor as your situation may have complexity that is not covered here.
