Before beginning this section, I want to be CLEAR that I am not providing tax, financial planning, or legal advice. The information below is to introduce you to another option for real estate investing. You should consult with your CPA, Financial Planner, and/or Attorney to see whether this information can benefit you in your overall financial plan and how best to implement it.
WHAT IS A SELF-DIRECTED INDIVIDUAL RETIREMENT ARRANGEMENT (IRA)?
A Self-Directed IRA is a variation on a Traditional or Roth IRA in which you control how the funds are invested rather than a fund manager. In addition to controlling where the money is invested, the self-directed IRA gives you more latitude to diversify your retirement portfolio. Possible investment options include, and are not limited to, public and private equities, various entities and enterprises, loans, some commodities and precious metals, and real estate.
WHAT ARE THE BENEFITS OF INCLUDING REAL ESTATE IN A SELF-DIRECTED IRA?
You can invest in what you know and are comfortable with. Many of my clients feel they understand real estate better than other asset classes and prefer to control their investment rather than rely on a fund manager. Real estate can really grow your IRA through potential appreciation as well as cash flow from the property. Even in an IRA real estate can be leveraged, potentially providing exponential growth of your investment. If structured and maintained properly, the Roth IRA can also help with estate tax planning.
It is very important to note that real estate purchased through an IRA is strictly for investment purposes and neither you nor your family members can live in the property. Unlike properties purchased through a 1031 exchange, real estate in an IRA can not be converted to personal residence.
HOW DO YOU ACCUMULATE ENOUGH FUNDS TO PURCHASE REAL ESTATE IN YOUR IRA?
With high property values, it may seem difficult to accumulate enough funds to purchase real estate. Younger investors haven’t had enough time to accumulate funds necessary to purchase real estate. Older investors may just now be hearing about the Self-Directed IRA and have massive retirement savings tied up in other types of retirement funds, which may be restrictive. There are several ways to purchase real estate with self-directed IRAs.
Investors can make an annual contribution to their IRA. The IRS has established annual contribution limits. The 2020 tax code allows an annual contribution of $6,000 ($7,000 if you’re age 50 or older), or your taxable compensation for the year, if your compensation is less than this dollar limit. Given these limits, it may take quite some time to have enough saved to purchase real estate. The good news is that multiple IRA accounts can be used in combination to purchase real estate. For example, a married couple can combine their IRA accounts to purchase real estate.
Data referral from www.irs.gov
In addition to combining IRA accounts to purchase property, you can also finance real estate purchased in an IRA. The IRA requires that any financing is non-recourse, which limits the number of potential funding sources and typically increases the amount of down payment required. For a lender to be comfortable with a non-recourse loan, the loan to value will have to be pretty low. While typical investment financing maximums (50-75%) may not be available, lower financing limits will still help with purchasing real estate through your IRA sooner than later.
Rolling funds over and/or transferring funds from other investment accounts to a self-directed IRA is common way to accumulate enough funds to purchase real estate. Generally, you can move funds from another retirement account to an IRA once a year. The funds can be deposited from the originating fund directly to the receiving IRA. If the funds are paid directly to you, they must be deposited into the self-directed IRA within 60 days. As you can tell from the IRS chart below, this can be complicated and I strongly recommend you consult with your CPA, Financial Planner, and/or Attorney regarding the pros and cons of executing a rollover before making a final decision.
TRADITIONAL OR ROTH IRA?
There are many differences between the two, but the biggest differences are in the tax treatment of the funds going in and coming out. With a Traditional IRA, the initial investment is pre-tax dollars, providing a tax benefit in the year they are deposited, and you pay taxes when you start to take distributions. There is a tax on the growth. With the Roth IRA, the initial investment is after tax dollars, providing no tax advantage in the year they are deposited, and there is no tax when you start to take distributions. That means the income generated from the property over the years as well as the appreciation are tax free with a Roth IRA!
All expenses and income remain in the IRA. That means that any and all expenses need to be paid from the IRA funds. You CAN NOT pay for repairs or renovations with personal funds. All income also stays in the fund until you are eligible for disbursements.
You need to understand that the risk from your investment using a Self-Directed IRA is on you. Self-Directed means exactly that and you take credit for good performance and responsibility for bad performance. The plan administrator merely facilitates the fund and your instructions. They do not give investment advice.
There are several companies that provide Self-Directed IRA account administration. Each of them has their own service offerings, pricing, and standards of practice. Check out the details of the services they provide as well as what you can and cannot do with them before opening your Self-Directed IRA.