Mortgages & Creative Financing

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

Expertise: Business Management, Landlording & Rental Properties, Real Estate News & Commentary, Real Estate Marketing, Personal Development, Real Estate Investing Basics
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The real estate market is growing in most of the markets in the country, and people are looking to get in on the game any way they can. One of the more unusual tactics for snagging a slice of the pie is to invest indirectly by directing your investment retirement account (IRA) to invest in real estate for you. Here's how it works.

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Self-Direction is the Key

A self-directed IRA isn’t like a normal IRA; it requires that you hire someone to act as the trustee or custodian of the account while you act as the director, deciding what to invest the accounts funds in. In addition to the normal vehicles like stocks, bonds, and mutual funds, they allow you to invest in unusual vehicles, such as small businesses, boat slips, and, of course, real estate. But there are a few hoops you have to jump through to make an investment in real estate with a self-directed IRA.

Hoop #1: Separation of Entities

Your IRA is not you, and you cannot put your name on anything your IRA invests in. The correct title of the entity that is doing the investment is almost always "[Name of Company] Custodian FBO (meaning "for benefit of") [Your Name] IRA." For example, if you hire the Plymouth Trust Company and your name is Travis Witchert, the title of the entity doing the investment is "Plymouth Trust Company Custodian FBO Travis Witchert IRA." This means that, among other things, you cannot use a 1031 exchange or take advantage of the real estate depreciation tax breaks, as you are not the one who is invested in the property.

Related: Take Advantage of an Underused Law — and Invest Using Your Self-Directed IRA

Pro Tip: One of the more common and useful “tricks” you can do as part of this process is to set up a limited liability company with yourself as the manager and then have the IRA invest in your LLC. This doesn’t get you around any of the other hoops or limitations below, but it does move direct control of the IRA’s “effective checkbook” from the custodian above and put it back in your hands. If you don’t do this, you have to consult with the custodian when you want the IRA to spend its money on something; if you do use the LLC trick, you can invest when you want to and how you want to. Consult your financial advisor for more details.


Hoop #2: Non-Recourse Loans Only

An IRA can obtain financing to invest in property (but see “The Second Catch” below!) For an IRA, however, financing is only allowed to be in the form of “non-recourse” loans. These are loans wherein only the property itself is allowed as collateral, and the lender cannot pursue the IRA's funds directly if the IRA defaults. Non-recourse loans make defaulting significantly more damaging, especially if you get near to paying the loan off before you default, as there is no situation where your IRA will retain ownership or control of the property if it defaults.

Hoop #3: Disqualified Persons

You cannot use your IRA to purchase property that you or a disqualified person owns. You also cannot partner with a disqualified person to purchase shares/equity in an investment property. Disqualified people include your parents, siblings, children, spouse, or in-laws of those. This is to prevent "self-dealing," which is against the rules of an IRA.

Once your IRA has acquired an investment property, you aren’t free to use the property however you wish. Being a separate entity from your IRA isn’t your only limitation, either—there are a number of rules you must follow that are designed to ensure your IRA isn’t being used for the wrong reasons. Those rules can be summarized in two significant limitations:

Limitation #1: You cannot benefit from the property at all before you retire.

The explicit purpose of an IRA is to set yourself up for retirement—and to ensure that the IRA remains 100 percent focused on that purpose, you cannot benefit directly or indirectly from your investment in any way other than to increase the amount of money your IRA controls. This means you cannot, for example, rent space to yourself or start a time-share in a home you invest in and then purchase shares of the time-share from your IRA or arguably even give your granddaughter’s Girl Scout troop permission to sell on your property! In case it’s not obvious, this also means that 100 percent of the income from your IRA’s rental property gets paid directly into your IRA as well.

Limitation #2: Your IRA cannot benefit from you, either.

Any and all expenses related to your IRA’s investment property must be paid by the IRA itself. This includes predictable expenses like property taxes and management fees and unpredictable expenses like major repairs and eviction costs. No fair, absorbing the risk so your IRA gets all the reward! Similarly, you cannot work on the house yourself in order to increase its value—the IRS sees your “sweat equity” as a kind of payment to your IRA. As mentioned, that’s not something the IRS sees kindly. So don’t do it.

Why Would You Want to Use Your IRA For Property Investment?

The major reason a person would want to invest at all with an IRA is taxes. Profit that an IRA makes is tax-deferred (or in the case of a Roth IRA, you pay taxes on funds put in, but not taken out—which means you don't pay taxes at all on any gains made!). This means that any profit that sits in your account can get re-invested or otherwise earn interest for decades before you have to pay taxes on it—meaning it's gaining ~25-30% more than if you had to pay taxes up front. But there are catches!

The First Catch: Capital Gains vs. Income Taxes

Real estate investments that occur outside of an IRA are subject to capital gains taxes, which generally cap out around 20%. But real estate investments that are performed by a traditional IRA are subject to income taxes, which cap out near 40%. It can take careful math to determine whether or not the difference between 20%-as-you-go and 40%-at-the-end is worth it, so be ready to sit down and put in the work to calculate it out. (Alternately, set yourself up with a self-directed Roth IRA and skip out on the taxes entirely. That’s the real win!)


Related: 3 Pros (& 2 Cons) of Self-Directed IRA Investing

The Second Catch: Business Income vs. Investment Income and the UBIT

IRAs can totally get financing, as mentioned above—but if they do, they open themselves up to tax liability. The IRS considers income from debt-financed investments to be “business income” rather than “investment income,” and “business income” is subject to a nasty tax called the Unrelated Business Income Tax. So if you finance 33% of your property, the IRS will assume 33% of the income from that property is “business income” and the UBIT—which can run at income-tax levels!—will apply, even for a Roth IRA.

After all that, if treated carefully (and calculated out thoroughly), the tax benefits of investing in real estate with a self-directed IRA are still significant. There’s also the advantage of diversification; if your IRA currently only holds stocks, bonds, and mutual funds, a careful dip into the real estate market can add stability to its portfolio. The decision to use an IRA to invest in real estate should be made in full knowledge of the consequences, but for many investors, it should be made.

Have you ever investing using your IRA (or is this something you’d consider doing)? Why or why not?

Leave your comments below!

While in the mortgage business, Drew rose to a VP position at the first broker he worked for and then started his own company. In the pursuit of excellence, he obtained several mortgage designation...
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    Susan Maneck Investor from Jackson, Mississippi
    Replied about 3 years ago
    As someone who owns a solo401K and helps my mother manage her self-directed IRA I would like to point out the following: 1. I would not buy real estate with any kind of retirement fund if I had the option of buying real estate outside of it for the simple reason you lose all the tax breaks that real estate investment provides. I established a solo401K for this purpose only when I had used up my other resources. 2. If you have any self-employment income whatsoever, I would favor a solo401K over a self-directed IRA. There is much less bureaucracy involved. You don’t need an LLC and you can be the custodian of your own account. No way around the no-recourse loans or the need to avoid disqualified persons, however. If your self-employment is only part-time (as mine was) producing minimal income, you can roll-over your other retirement accounts into it in order to produce adequate income. 3. In regards to the “catch” you mention of a 40% tax bracket, if your taxable income is going to be over 400,000 which is what it takes to be be in the 39% tax bracket, why would you have a traditional IRA to begin with? What you need then is a RothIRA or Roth401K. Until you are 70 and are required to take minimum distributions you decide how much you withdraw and therefore your income bracket. Incidentally, the home I live in was financed via a loan I made through my solo401K. Feels really nice to own my home free and clear, except I have to pay myself back for it at 4.25 percent interest amortized over 15 years. Mind you, you can’t finance more than 50K this way, but I bought my house for 30K.
    Drew Sygit Property Manager from Birmingham, MI
    Replied about 3 years ago
    @SUSAN MANECK: thanks for your comments. Many people use their retirement funds to invest in real estate as they don’t have cash to do so. Always check with a competent tax professional before doing any of this:)
    Mike Reynolds construction from Nacogdoches, Texas
    Replied about 3 years ago
    I thought a loan from a solo k had only a ten year payback.
    Mike Reynolds construction from Nacogdoches, Texas
    Replied about 3 years ago
    Sorry I meant five year payback.
    Konstantin Ginzburg Investor from Hopkins, Minnesota
    Replied about 3 years ago
    Susan, could you elaborate on these points? What are the main differences between self-directed IRA and solo401K? And why would you not have a traditional IRA to defer 40% taxes now rather than opt for no taxes in the future? Isn’t it more of a guessing game where taxes will be at the time of your retirement as well as potentially diversifying your future incomes into both taxable and non-taxable streams?
    Mike Reynolds construction from Nacogdoches, Texas
    Replied about 3 years ago
    A solo is for people who have self employment income. It’s the same as a regular run of the mill company 401k but a solo is for a one person company. You being that person.
    Bernie Neyer Investor from Chanute, Kansas
    Replied about 3 years ago
    Is there anyone who could recommend a trust company for the IRA/401k? I’ve tried finding some, but the ones I’ve run across I’ve never heard of. Local banks think a self directed IRA means I can invest in either their CD or some stock, but that is all they allow. I’ve contacted large banks, but they shy away from what they call closely held investments. You could also become a hard money lender through your self directed IRA. I’ve been told you can’t run every loan through there, but a couple a year is good. The problem I’ve had with doing this, is no one is willing to share who their trustee is.
    Drew Sygit Property Manager from Birmingham, MI
    Replied about 3 years ago
    @BERNIE NEYER: here are some, but do you own due diligence: Community National Bank Equity Trust Company (acquired Sterling Trust Company) First Trust Company of Onaga IRA Services Trust Company Kingdom Trust Company Millennium Trust Company Pensco Trust Company (acquired Lincoln Trust Company) Provident Trust Group Trust Company of America Advanta IRA (TPA) GoldStar Trust Company Midland IRA (TPA) New Direction IRA (TPA) Next Generation Trust Services (TPA) NuView IRA (TPA) Quest IRA (TPA) Self Directed IRA Services, Inc. (Horizon Bank) SunWest Trust Company Vantage IRA (TPA)
    Shawn Deufel from Charleston, South Carolina
    Replied almost 3 years ago
    If I were to set up my real estate investment property as an LLC that I manage (1% ownership, no investment), and my self directed IRA invested in (99% ownership, all investment), would this effectively bypass all the limitations (non-recourse debt, UBIT from debt financed property, no benefits allowed to me personally)? The self directed IRA would just pull cash flow and all the proceeds from eventual sale, while I (potentially) pulled management fees.
    Drew Sygit Property Manager from Birmingham, MI
    Replied almost 3 years ago
    @SHAWN DEUFEL: we know of several investors that have done this. Lending to an LLC, that then does the investing, gives you more control over the process. Please check with a qualified tax professional though to set this up.
    JoAne Baptiste Rental Property Investor from New York, NY
    Replied over 1 year ago
    I’ve been looking to recharge my RE investments with IRA funds. Very informative stuff ! Thank you