Real estate is one of the most popular alternative assets when an investor wants to shy away from the traditional avenues like bonds and stocks. Regardless of its popularity, it’s not necessarily accessible to everyone, namely because the amount needed up front is steep. What more and more retirement savers are discovering is that with the right help and resources, they’re able to use their retirement funds to invest in real estate.
Not all retirement accounts are created equal, a majority of IRAs (individual retirement accounts) are managed by an advisor, and the advisor chooses what your funds are invested in. With a self-directed IRA, you’re the one making the decisions, you’re the one directing your investments, so here’s what you should know about investing with a self-directed IRA.
When you open, contribute and use a Traditional self-directed IRA, the income earned off of your investments grow pre-tax. This means that when it comes time to retire, and you take monthly distributions, your retirement income will be taxed as income.
The other option you have is what’s called a Roth IRA, and when you open, contribute and use a Roth self-directed IRA, your earned income is contributed after-tax. When you reach retirement age, your Roth IRA distributions are not taxed.
Which type of account you open is up to you, but the differences are stark. Talking to your tax accountant is the best route for deciding which account is best for you.
As a real estate investor, you can easily leverage your IRA by using a percentage of the funds in your IRA to purchase your chosen property and use a non-recourse loan to fund the remaining balance. The reason that you may choose a non-recourse loan over a personal loan is that the non-recourse loan is tied to the real estate it pays for, and not your credit personally. In the case of a default, the lender would seize the real estate property without touching any of your other property or assets. Two things to keep in mind though, one is that the non-recourse loan may have a higher interest as compared to a regular loan, and two, it may be difficult to get approved, since banks are looking at a non-recourse loan as more of a risk for them.
The main reason investors choose real estate is the income that’s earned by either buying and flipping for resale or to rent out to businesses or to families. However you choose to utilize the property, it’s important to note that since you’re buying the property with your self-directed IRA, it’s your IRA that owns the property. This means that any gains made on your investment go straight back into your IRA, and vice versa, any money spent on repairs or taxes come from your IRA as well.
As with any investment, there are risks and some rules that could be deal breakers for some investors. Familiarizing yourself with the self-directed IRA rules and following them is just simply a part of the process. Violating rules that are set by the IRS could cause your IRA to get disqualified, and get you fined a percentage of the amount in your IRA.
The property in question cannot be used as a vacation house, or a secondary residence, or be rented out to immediate family. You’re also not allowed to do repairs or fixes yourself, you will always have to be at an arm’s length when it comes to your property.
One other possibility is that you could run into UBIT, which stands for Unrelated Business Income Tax. UBIT isn’t scary, nor does it mean you’ve done something illegal, it’s just a tax that your IRA will pay when using debt leverage to buy property, or does a deal with an organization that doesn’t pay corporate taxes.