When I started real estate investing, one of the first hurdles I needed to jump was startup capital. I saved a bit of cash and partnered with a couple of private lenders in my sphere of influence, but in addition, I also was able to use an old 401K by moving the funds into a Self-Directed IRA. This was a prudent move for me, which I learned by having some in-depth discussions with my team members, especially my tax professional, accountant and attorney. All situations are different, so before moving forward, investors should make sure to discuss options thoroughly with their team members.

The basics of an IRA (Individual Retirement Account)

Traditional vs. Roth IRA

In a traditional IRA, contributions can be tax-deductible in the year the contributions are made, but withdrawals are subject to taxes.

In a Roth IRA, contributions have no impact on taxes when they are made, but withdrawals in retirement can be made without being taxed.

Either type can be used for real estate investing as long as real estate investing is allowed by the custodian.

Regular vs. Self-Directed IRA

Every IRA needs a Custodian or Trustee, typically a company, who services the account. A custodian of a regular IRA will typically limit investors to traditional investment vehicles, such as stocks, bonds or mutual funds.A custodian of a Self-Directed IRA will allow a much wider range of investments: privately held companies, real estate, etc., in addition to stocks, bonds and mutual funds. The IRS does not specify what can be invested in, only what can’t: collectibles, life insurance, vacation homes which would be used at any time by the investor or buying or selling an asset to a disqualified person (like a family member).

How to Invest in Real Estate Using a Self-Directed IRA

Rules and Risks When Purchasing Investment Property Through an IRA

When investing in real estate using an IRA, it is necessary to follow the IRS rules and the policies of the custodian, as failing to do so could result in the IRA becoming disqualified from receiving tax benefits.

When purchasing an investment property through an IRA, funds cannot simply be added to the IRA as needed. This is one of the biggest mistakes an investor can make when owning property in an IRA.

For example, say an investor decides to do a fix and flip in their self-directed Roth IRA. They fund the IRA with $200,000 from a qualified plan from an old employer. Their acquisition cost is $150,000 and the rehab budget is $30,000.So far so good, they have a $20,000 cushion. However, let’s say the flip ended up needing a new HVAC system for $9,000 and the buyer’s home inspector uncovers structural issues that will cost $22,000 to repair. They cannot simply add the $11,000 shortage from their savings account to the IRA because there is a per-year maximum IRA contribution limit. Also, due to IRA rules, they cannot do any of the work themselves, even if they are a qualified and licensed contractor.

A similar scenario can exist with rental property, especially early on in the tenancy before enough funds have been built up in the IRA to handle major repairs.

Proper planning, in the beginning, can help reduce these risks. Specifically, having a game plan as to where the cash will come from if the investment needs a quick injection of cash. Some options include the yearly IRA contribution, additional rollover into the IRA from another retirement account or to find a lender who will lend directly to the IRA.

Consulting Financial and Tax Professionals

Prior to moving funds, real estate investors should seek out the advice of a trusted financial advisor and tax professional who can help them fully understand the risks and rules of investing in real estate via an IRA. These professionals should also look at the investor’s big picture financial plan and assess how this real estate investing strategy fits into it.

Finding an IRA Custodian

When searching for a custodian, investors should verify that a potential candidate has a thorough knowledge of the rules and regulations governing real estate investing through an IRA. Once their expertise has been established, other items of importance to the investor are: understanding the closing process used by the custodian, how the property will be titled, timeframes, fees and their specific policies. Each custodian has unique procedures on how an investor can fund, or make the initial deposit, and how bills and expenses are paid from the IRA. It is important to understand these procedures so the right custodian can be chosen to match the specific needs of the investor.

Managing an Investment Property in an IRA

Those investing in rentals or fix and flip properties will need to treat the property in the IRA a bit differently than a property owned outside of an IRA. First and foremost, the investor cannot receive any immediate personal benefit from the property, like using the home for a personal vacation or paying themselves to do maintenance work on the property. Investors must make sure all transactions are run through the custodian, as the custodian will report income and expenses to the IRS to make sure the account is following the IRS rules, reducing the risk of disqualification.

With proper planning and a thorough understanding of the rules and risk, retirement accounts can be incorporated into an investor’s real estate investment strategy.