Invest in Real Estate Using Your Roth IRA

by | BiggerPockets.com

As an investor looking to build wealth and retire early, you’ve likely considered taking advantage of a Roth IRA, a special type of retirement account that doesn’t require you to pay taxes—provided certain conditions are met, like a minimum age for withdrawal.

In a Roth IRA, you can contribute up to $6,000 per year (in 2019) and use those funds to invest in assets like stocks and bonds.

If you’re reading this blog, you’ve probably also considered investing in real estate as a way to build your wealth, whether through flipping properties, renting or leasing, or hanging on to real estate long-term with the hope its value increases over time.

What you may not realize is it’s possible to invest in real estate using funds allocated to your Roth IRA—in other words, holding real estate within your Roth IRA. But is this a good idea?

Self-Directed Roth IRAs

Traditional IRAs only allow you to buy and exchange conventional assets like stocks, bonds, ETFs, and mutual funds. However, you also have the option of pursuing a self-directed IRA. These accounts have the same tax advantages as their traditional counterparts, but offer more flexibility with what you can buy and sell.

For example, you can use the funds of a self-directed Roth IRA to hold partnerships, tax liens, single-family homes, multiplex homes, apartments, co-ops, condominiums, or even vacant land.

The catch is, you’ll need a “custodian” (an individual or a service) to handle your account. Finding a custodian that specializes in self-directed IRAs can be tricky.

The popular names you’ve heard associated with Roth IRAs may not offer a self-directed option for the sake of keeping their business models simple and approachable. You’ll need to find someone capable of understanding the ins and outs of real estate purchases, in addition to being a self-directed IRA custodian.

Related: The 5 Best Investments in My Self-Directed IRA

envelope with cash and change falling out labeled Roth IRA in permanent marker with glasses on a desktop

Advantages of Roth IRAs

So, what are the advantages of using funds contributed to your Roth IRA to purchase real estate?

  • Tax-free growth. The biggest advantage here is the potential for tax-free growth. Assets held in a Roth IRA can essentially grow tax-free, provided you don’t withdraw the gains before you’re 59.5 years old. The stipulation here is that only Roth IRA funds can be used to purchase the property to see this benefit. It’s possible to finance part of the home, but only the equity paid for with Roth IRA funds will be eligible for the tax-free benefits.
  • Tax-free rental income. Assuming you’ve paid for the house entirely with Roth IRA funds, you’ll be eligible to collect tax-free rental income. Of course, things get more complicated if you’ve financed your home with funds or a mortgage outside your Roth IRA.
  • Consolidation. Keeping your real estate within the confines of your Roth IRA may also make it easier for some people to segment their real estate investing strategies. One or a handful of properties can serve as your “retirement” portfolio, while you pursue other interests outside the Roth IRA.

Related: The Ultimate Guide to Real Estate Taxes & Deductions

Disadvantages to Roth IRAs

To be sure, there are a few disadvantages to this approach.

  • Finding a custodian. Not all Roth IRA custodians are willing or qualified to take on a client trying to purchase real estate. This can be a long and messy process, and not everyone who claims to be able to handle these transactions is worth working with.
  • Dealing with fees. Some custodians charge extra fees for complex transactions, especially those that handle real estate. This could potentially cut into the value of your deals or the profitability of your purchases.
  • The complexities of partial ownership. As you’ve seen in the preceding sections, things can get complicated if you’re using your Roth IRA funds to purchase only part of a home or as a down payment. Taxes can get complicated, as well, unless you’re paying for the entirety of the property.
  • Depreciation claims. Under normal circumstances, it’s possible to claim depreciation on your rental property as a way to save money on taxes. However, this isn’t possible if you’re holding the property in a Roth IRA.
  • Limits on personal maintenance and property use. You also can’t use the property for certain functions if you’re holding it in a self-directed Roth IRA. For example, you can’t live in it or run a business with it, and you may not be allowed to personally maintain it.

binder labeled REIT, calculator, house figurine on desktop

REITs: An Investment Alternative

If you’re hoping to get some real estate exposure in your existing Roth IRA without dealing with the complexities of self-direction or real estate ownership, there is an alternative: real estate investment trusts, or REITs. REITs can be bought and sold much like traditional assets like stocks and bonds, but they represent fractional shares of ownership in a selection of properties—like apartment complexes, residential properties, healthcare facilities, office buildings, and more.

Since you won’t be able to live in or directly manage the property you’d buy within a self-directed Roth IRA anyway, this isn’t much of a difference.

Key Takeaways

It’s definitely possible to purchase a property using your Roth IRA, provided you have a self-directed account. But considering the sheer number of complexities involved, you’ll have to decide for yourself if it’s worth the extra effort.

In some situations, this can be an advantageous way to secure practically tax-free growth for your property. But in others, it’s better to stick to investing in REITs within your Roth IRA, while purchasing any real properties with other funds.

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Want to learn how you could be saving more on your real estate taxes using loopholes, deductions, and more? Get the inside scoop from Amanda Han and Matthew MacFarland, real estate investors and CPAs, in Tax Strategies for the Savvy Real Estate Investor. Pick up your copy from the BiggerPockets bookstore today!

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Do you have a Roth IRA? Would you ever use it to purchase real estate? Why or why not?

Discuss in the comment section below!

About Author

Larry Alton

Larry is an independent, full-time writer and consultant. His writing covers a broad range of topics including business, investment and technology. His contributions include Entrepreneur Media, TechCrunch, and Inc.com. When he is not writing, Larry assists both entrepreneurs and mid-market businesses in optimizing strategies for growth, cost cutting, and operational optimization. As an avid real estate investor, Larry cut his teeth in the early 2000s buying land and small single family properties. He has since acquired and flipped over 30 parcels and small homes across the United States. While Larry’s real estate investing experience is a side passion, he will affirm his experience and know-how in real estate investing is derived more from his failures than his successes.

8 Comments

  1. margie kohlhaas

    Thanks for listing out all the options. I personally have not invested my IRA in Real Estate. I have an account with USAA that allows me to purchase & sell stocks. I do the same for my daughter’s Coverdell. So far, I’ve been doing well not keeping all my eggs in one basket and having the ease & flexibility to buy & sell stocks. I am intrigued about the possibilities but it sounds like having a proper structure and a custodian that you trust are key elements of the process.

  2. Pete Loshigian

    I’m concerned about starting my real estate investing with a self directed retirement account due to the complexities mentioned and being a newbie.

    I am allowed to take a loan from my Roth 401k at less than 4% interest and it can be repaid over 60 months. Any thoughts on doing so to come up with a down payment on my first investment property vs. just taking a withdrawal and paying a penalty? I figure if I can’t pay the loan back then I can always take it as an early withdrawal later and pay the penalty later. If I pay a penalty or pay a property manager I figure it’s all the same, but would rather be able to increase my margin by being able to maintain and manage the property myself and also receive some tax benefits now.

    Also, does anyone know if I were to invest in a self directed IRA and then supplemented with a loan from my Roth 401k if that would be considered mixing retirement and non-retirement funds?

    • Dmitriy Fomichenko

      PETE,

      When you invest using self-directed IRA all transactions must be “arms length”, meaning no “disqualified person” (yourself and your immediate family members) can be involved in the transaction. If you take a loan from the 401k – this becomes your personal funds, co-investing alongside with your IRA personally most likely will result in a prohibited transaction – don’t do it!

      • Pete Loshigian

        Thanks for the response Dmitriy,
        that makes sense because I can use a loan from the 401k to buy anything else for personal use.

        Do you have any thoughts on borrowing from my 401k vs. taking an early withdrawal? It looks like I can withdraw from my ROTH 401k and just pay taxes on the earnings, or I can take a loan of up to 50k and pay around 4% interest.

        Obviously if I take a loan that means I need to generate additional cash flow to pay it back, plus I’m limited to fifty thousand. The advantage I can see is in the future I can always give myself another low interest loan for renovations or emergencies if they arise, plus it appears it’s a loan against my assets in the account so I can continue to invest the principle during the loan period so I can potentially offset the cost of interest with investment returns. Currently I’m in cash due to market volatility and my desire to invest in real estate.

        If I take a withdrawal, then I pay income tax plus 10% penalty on the earnings only, plus if I’m earning at least 10% on the rental property that offsets the penalty. So really I’m looking at 10% penalty on earnings vs 4% interest on loan, since about 50% is earnings then the effective penalty is really 5% of the withdrawal (10% of 50%) vs. 4% interest. If I take the loan and default it turns into a withdrawal anyway.

        This may be over-analysis, which is why I haven’t gotten my first property yet…

        So as I write this, essentially I’d pay about 1% more for a withdrawal vs. loan, but the loan allows me to continue investing in my Roth 401k tax free (and probably subtract my loan payment from my income for tax purposes) and the withdrawal allows me to invest in real estate with a smaller profit margin because I don’t have to cover a loan payment. That might be the most important thing since I’m in a very expensive market.

        Is it a waste of time to try to figure this out until I find a property and can determine how much cash flow I can expect to generate, and if I have a big enough margin to cover a loan payment also then borrow, but if my cash flow from the property isn’t as good then withdraw? Thanks in advance for reading my neurotic post if you got this far! 🙂

        • Dmitriy Fomichenko

          Pete, generally I don’t like the idea of taking early distribution, paying taxes and penalties. Especially on tax-free account such as Roth 401k. And taking a loan means you eliminating the opportunity for your funds to grow tax-free. There are number of facts to consider: time horizon, available investment options, your current and future income as well as tax bracket, investment potential and more. I would suggest discussing this with your CPA.

  3. Dmitriy Fomichenko

    Thank you Larry for the detailed article!

    Under disadvantages you list that depreciation can’t be claimed as a way to save money on taxes. However, when investing in real estate inside of a Roth IRA all of the rental income is tax-free, because it is inside of a tax-sheltered vehicle! Therefore depreciation deduction can’t be used because there is no taxable income.

    Now, when leverage is used to finance a purchase of a rental property inside of an IRA this will result in portion of the income that is derived from the financed portion of the property be considered Unrelated Debt Financed Income (UDF) and therefore be subject to UBIT (Unrelated Business Income Tax). This is the tax that IRA is responsible for. In this case depreciation deduction CAN be used to offset this income along with the prorated portion of all other expenses such as property taxes, insurance, repairs, maintenance, property management fees, etc. Hope this helps!

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