Real estate investment is considered the most common alternative asset to explore when engaging in self-directed investment, which can open numerous doors for the savvy investor.
There are significant advantages to investing in real estate using an SDIRA; however, it is also important to be aware of its drawbacks. Whether you choose to engage in house flipping during a prosperous market, invest in beachfront rentals, or become a landlord, real estate has the potential for substantial financial rewards.
Before making any significant investment decisions, it is essential to conduct thorough research to determine if the real estate market aligns with your goals. Presented here are the ten most noteworthy advantages and disadvantages of self-directed real estate investment.
10 Pros and Cons of Self-Directed IRA Real Estate
1. Pro – Tax-Free or Tax-Deferred Account Growth
Your real estate investments can grow tax-advantaged by utilizing a self-directed IRA. If you opt for a traditional SDIRA, your contributions have the potential to grow tax-deferred, whereas with Roth IRA contributions, you can withdraw the funds tax-free after you retire. These tax benefits can lead to significant accumulation of wealth as your real estate investment expands.
2. Con – Unrelated Debt-Financed Income
UDFI can be incurred when any property being held generates income. Any profits from such property that are owed at any point during the tax year can result in a penalty. This penalty can be triggered by corporate stock, tangible personal property, and frequently by real estate. If you utilize a loan to acquire property for your SDIRA, the income derived from that property would be susceptible to UDFI. If you are unable to provide the funds immediately, you may be required to face the penalties if you wish to invest.
3. Pro – Control over Your Property Choices
It is up to you, as the account holder, to determine the course of action for your real estate. You have the authority to establish the price, make modifications to the property, and choose whether to rent or sell. If you possess sufficient skills, you can potentially sell the property quickly for a profit, or alternatively, you can opt to maintain it as a landlord. Whichever option aligns better with your investment strategy, you have complete control over it, and it will thrive under your direct influence.
4. Con – Fluctuating Market
Selling a home can be challenging due to the rapid fluctuations in the real estate market. If your goal is to buy and sell properties quickly for profit, you may encounter difficulties in a slow market. There are instances when you may have to hold onto a purchased home for a certain period of time, as it may not be easily sold. In such cases, the decrease in value is not considered. It is important to approach real estate investment with patience and exercise caution.
5. Pro-Protected Investments
If you encounter any financial difficulties, your SDIRA will safeguard your real estate investment. Creditors cannot touch self-directed IRA funds, providing protection even in cases of bankruptcy or hardship. Your properties held within the IRA will remain secure.
6. Con – Pricey Investment
Purchasing real estate comes with a high expense, so it is not unexpected. Even when buying property at a lower price, it will still have a financial impact. This includes factoring in the costs of closing fees, upgrades, taxes, and maintenance, making real estate quite costly. While not all individuals have the immediate funds for these transactions, as stated before, obtaining a loan through your IRA presents its own challenges.
7. Pro – High Return on Investment
Real estate investment can produce beneficial outcomes if executed correctly. When contrasted with conventional stocks, bonds, and mutual funds, real estate offers a greater return on investment. If you possess the necessary funds and are willing to exercise patience, investing in real estate has the potential to enhance your retirement plans.
8. Con – Third Party Involvement
To enjoy the benefits of an SDIRA, the IRS mandates that a certified IRA custodian be involved to hold the account. Your custodian must approve any investments, including funds being released. Additionally, the custodian is responsible for monitoring your account transactions for IRS reporting. Regrettably, this could delay accessing cash quickly. While having an LLC account may grant “checkbook” control, you still need to report your transactions to a custodian.
9. Pro – Opening an LLC
You can acquire checkbook control and bypass intermediaries by establishing a limited liability company using your SDIRA. There is no need to wait for administrators for transactions and you are able to buy whatever you require using your IRA funds. As a real estate investor, it may be necessary to act swiftly on a purchase or have fast access to funds. Having an LLC grants you the necessary control. However, you are still required to inform your custodian, but you only have to pay fees for a single meeting instead of multiple ones.
10. Con – Restrictions and Possible Disqualification
Assuming responsibility for your own investments requires a significant amount of accountability. This implies that account holders must conduct thorough research and strictly adhere to regulations in order to prevent any potential penalties. For instance, it is forbidden to utilize property owned by your IRA, and individuals who are disqualified but may potentially benefit from your savings are also prohibited from doing so. Furthermore, you cannot be personally involved with the investment or utilize personal funds to enhance it. Profiting from your real estate investment is only permissible post-retirement. As you explore the various possibilities, exercise caution and safeguard your investments.
Why Focus on Real Estate?
Real estate holds the characteristics of being real, tangible, and limited, and has traditionally served as a long-term method for generating wealth over multiple generations. Instead of being viewed as an alternative option for retirement investments, real estate can serve as a fundamental means for expanding one’s IRA account.
Why Would Someone Go the Self-Directed Route?
Consider whether we want to rely solely on Wall Street and money managers for our entire retirement future. Or do we trust ourselves enough to have some control over our funds and know where our money is invested? A number of investors are of the belief that surrendering absolute control of their retirement to money managers or Wall Street may not be the most favorable approach for them.
Through conducting research on real estate investments and sponsors, you can acquire the assurance to independently make decisions. Additionally, you may discover that real estate offers diversification and the possibility of superior returns, with a quicker pace, compared to conventional investments.
How It Works
To go the self-directed route, there are two options available. One option is to deposit the money through a custodian that specializes in self-directed IRAs. The other option is to open and deposit the funds through a checkbook IRA account. Regardless of the chosen method, it is essential to thoroughly research the investment’s potential and risks as it will be self-directed. In cases where there is a debt involved, it is important for it to be non-recourse. Keeping proper records is of utmost importance.
To avoid issues with traditional brokerages that do not allow non-traditional investments in IRAs and 401(k) accounts, you will need to transfer your funds from your current account to an IRA custodian that deals with self-directed accounts, like Provident or IRA Services Trust Company. It is important to adhere to the rules and choose a trustworthy custodian to ensure a successful management of your IRA investments.
What Are the Rules for Investing Directly in Real Estate?
The initial guideline is to strictly adhere to the rules. If you violate the rules by improperly purchasing real estate with an IRA, it can result in the IRA losing its qualification, leading to all the funds becoming taxable. The rules encompass several aspects, namely refraining from engaging in self-dealing (purchasing or selling to or from a related party), abstaining from making physical improvements to the property through personal labor, and avoiding personal benefits such as residing in the property yourself or renting it to a family member.
If you invest $100,000 from your IRA to purchase a rental property and allow your son and his family to live in it, regardless of whether rent is paid or not, the investment will be considered disapproved. In the event that the IRS uncovers this investment, it could be treated as a complete distribution and result in subsequent taxable penalties.
The real estate should exclusively be used for investment purposes, and typically, both the invested funds and dividends will pass through a custodian. Upon selling the property, the resulting proceeds will either return directly to the custodian or to the IRA checkbook account, allowing for reinvestment in case another opportunity arises.
What’s an Argument Against Using an IRA to Invest in Real Estate?
One main reason why using an IRA in this manner is discouraged is because it is unable to benefit from the advantageous tax shelters offered by real estate, such as depreciation and interest deductions. Similarly, stocks and bonds, which are typically utilized for IRA investments, lack these specific tax advantages. Hence, numerous individuals may view both types of investments as equivalent.
Investors older than 70½ must be aware of Required Minimum Distributions (RMDs) and how their real estate aligns with the necessary withdrawals, as real estate is considered an illiquid asset. For further information, refer to the IRS website (opens in new tab).
Getting Started
The initial step involves conducting thorough research. In the case of real estate, it is essential to research various aspects of the market, such as demographics, income, and job growth. It is also important to research the investment sponsor who will be responsible for managing your real estate investments on your behalf. Following this, the subsequent step is to research custodians. Even if you choose the self-directed approach, you will still need to work with a custodian who will handle the placement of your funds. It is crucial that any dividends or distributions are directed back to the custodian.
This article presents the views of our contributing adviser and was written by them, not the Kiplinger editorial staff. You can verify adviser records with the SEC or FINRA.
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