Real estate is a hard asset. When you invest your self-directed IRA funds into commercial and investment properties (not for personal or family use), these investments can count toward your retirement.
With uncertain global markets and exchanges threatening people’s investments, more and more investors are turning to assets that aren’t traded on Wall Street in order to bolster their Individual Retirement Accounts. In addition to traditional “safe havens” like precious metals, many people are utilizing their self-directed IRAs to invest in assets like real estate. While this may not be as secure an investment as gold or silver, it brings with it the possibility of real growth that outweighs the risk in many people’s minds.
Unlike a mutual fund where investment decisions are made on your behalf, a self-directed IRA allows you to actively select your own investments. You can still invest in mutual funds, stocks, and bonds, but you can also select investments you’ve chosen yourself, like land and homes, parking lots, storage units, and small businesses.
Real estate investors point to statistics indicating that real estate can actually generate even higher returns than you would see on the stock market, and you have a lot more personalized options.
The Real Estate IRA: How it Works
First of all, you need to hire a custodian or trustee—a position most often fulfilled by a brokerage firm—to hold your IRA assets, administer your account, and file all the required IRS documents. If real estate investment is your goal, be sure to select a custodian who allows for real estate investment in an IRA. Next you need to fund your IRA, which can be done with rollover funds from other IRAs.
Then you start selecting your real estate investments. For each contracted real estate development, you will sign a purchase agreement and turn over the mechanics of the deal to your custodian. The custodian will file necessary paperwork and release your IRA funds to the title company to make the purchase.
It will be important to avoid conflicts of interest, as well as prohibited uses. You can’t “invest” in your own home and use your IRA fund to make your mortgage payments. You can’t move into a property you purchased as an investment. You can’t invest in any company where you (or your spouse, or an immediate family member) have 50% or more interest. Basically, you can’t “double dip” by making an investment where you benefit at both ends. If you overstep these boundaries at any time—even by renting your property to someone related to you—the entire IRA would immediately forfeit its tax-exempt status and leave you on the hook for a lot of expense.
Choosing the Property for a Real Estate IRA
As you consider options for your IRA real estate investment, you would do well to select properties that will afford opportunities for income and growth. Know your landscape; if there are areas that are going to skyrocket in value due to population growth, those are solid investments. Properties purchased for resale have the added advantage of fewer hassles in the form of tenants and business interactions.
Many people opt for commercial properties with reliable tenants who are likely to stay long term. Consider properties like strip malls with long-term tenants and well-known anchor stores. Look for an NNN (“net, net, net”) lease that allocates expenses to the tenants in addition to their lease fees. An NNN lease might require tenants to pay portions of the property insurance, taxes, and maintenance of common areas as well as their set monthly rent.
Property Management for your IRA Real Estate
Real estate investment with a self-directed IRA has its complications. Unlike a precious metal, which sits in its vault without causing any headaches, properties need to be cared for and attended to. All of the taxes, insurance, maintenance, and other expenses have to be paid from your IRA. You may need to deal with tenants for the property, and contractors for maintenance and repair—and the whole time, every penny spent has to pass through the proper channels with your custodian.
Most real estate investors find that the best solution to these potential headaches is the hiring of a property management company. This entity will handle all the day to day actions and transactions of attending to the property, and remove a great deal of the hassle from your shoulders, for a set fee. A fairly standard cost of property management is ten percent of your total rents from the property, with an additional fee if the property managers sign a new tenant to fill a vacancy.
Tax Deferment with a Real Estate IRA
You may be wondering what the benefits could be of involving a middle-man custodian rather than simply investing outright in real estate. The answer lies in tax deferment, which is one of the great gains of an IRA.
The advantage is particularly noticeable if you start with a Roth IRA, where you pay taxes up front on the money you invest, rather than at the back end when you receive retirement distribution from the IRA. This effectively means that you are being taxed on the smaller (initial) amount rather than the larger (end) amount of an investment that has grown over time.
You roll over your Roth IRA funds into the self-directed IRA you have set up to handle real estate investing, and off you go! Whatever profits, income, and growth your investment accrues, that financial gain is essentially tax-free. And that, in a nutshell, is why people are willing to take on the extra hassles of using an IRA to do their real estate investing.
Mortgages and Down Payments with a Real Estate IRA
One of the attractive elements of a Real Estate IRA is the fact that you can purchase a large property with a (relatively) small down payment. This does leave you with the question of a mortgage on the property, and the tax consequences.
To boil down the numbers, the percentage of that property that you own outright (and the corresponding percentage of income from that portion of the property) remains tax-exempt and sheltered by your IRA. The mortgaged percentage and its incomes, however, will be subject to taxes.
With this breakdown in mind, it is easy to see that the more of the property you can pay for, the more lucrative your investment will be. Many people roll over pre-existing IRAs to fund their real estate investments, in addition to contributing the maximum allowable amount each year.
Advantages of the Real Estate IRA
If you are already inclined toward real estate investment, doing so through a Real Estate IRA holds marked advantages. Particularly if you use a Roth IRA, your income and capital gains are tax exempt. With beneficiary designations, your investment can be passed on to future generations. Your investments will be diversified beyond Wall Street stocks and bonds. And real estate purchased through an IRA is considered to be a secure asset, separate from your personal finances, and therefore protected in the case of personal bankruptcy. All in all, the advantages of a Real Estate IRA far outweigh the hassles.