What is a self-directed IRA? “Self-directed” is not a legally defined term, but an industry term for a retirement account that allows the owner to choose the investments. One option these investors can choose is real estate-related investments, along with a virtually unlimited list of other asset types, including alternatives like hedge funds. Since the 1974 ERISA laws came into being, it has been possible for your IRA and other qualified accounts to own real estate, whether land, a rental house, an office building, or apartments.
How Are They Created?
You can start a self-directed IRA by opening a new IRA or rolling over or transferring funds from previous employer-sponsored plans or custodians:
- Profit Sharing Plans
- Defined Benefit Plans
- 457 Plans
- Any Other Qualified Plan
Things to Know Beforehand
- Funds that are in an active 401(k) with a current employer typically cannot be utilized unless the plan allows true self-direction.
- Employees that are 59½ years old or older may be allowed an “in-service” distribution that allows funds in an active plan to be rolled over into an IRA without penalty.
- All IRAs can be self-directed.
Plan Types Eligible for Self-Direction
You can use any type of retirement plan for self-direction:
- Traditional or Rollover IRA
- Roth IRA
- Simplified Employee Plan (SEP)
- Savings Incentive Match Plan for Employees of Small Employers (SIMPLE)
- 401(k) Plan
IRS Rules and Investment Options in an IRA
The IRS does not approve or disapprove of all assets that you can invest in — there are no real approved investments as far as the IRS is concerned. They only tell us what is disallowed in an IRA, which is collectibles and life insurance, because a value cannot be established. Remember, the real estate and any income it generates or the cash from flipping properties stays inside the IRA — at least until you turn 59½, when you can legally withdraw it.
- Real Estate (Commercial, Residential, and Land)
- Private Lending
- Private Equity
- Limited Liability Companies (LLCs), Private Limited Partnerships (LLPs)
- Precious Metals
- Brokerage (Stocks, Bonds, ETFs and Mutual Funds)
In almost 95 percent of the existing IRAs in the United States, the brokerage option is exercised the most. Why? Because most brokerage firms do not have departments capable of administering these alternative (and in many cases too complex to administer) options. There are a few highly respected firms that can administer these other investment choices — Millennium Trust being the 800lb. gorilla in the room.
If you look at the IRS guidelines, they say it’s legal to invest in real estate. However, not all trustees or custodians (IRA providers) are required to offer real estate or other alternatives as investment options.
It’s Your IRA, But…
It’s not quite you investing personally with your own name — you’re actually using the IRA in its own identity. It acts as its own closed-loop legal entity separate from your personal finances. When the IRA makes an investment, the money leaves the account, it goes and purchases something, and then any income or profits from a sale comes right back into the IRA.
The other portion you need to understand is that when you have a self-directed IRA anywhere, it’s actually the provider or the IRA administrator that’s signing all the legal documents on behalf of the account because it’s always going to be titled in that name of your provider, not your name. For your benefit, it will include your name, but the name on the title will also be the account administrator.
Benefits of Buying Physical Real Estate in an IRA
- Income is created right away off of the properties’ cash flow.
- Real estate can be inspected and is usually easy to value.
- Real estate can be purchased below market and fixed up, thus adding value.
- Tax is not paid on income or profits.
Downsides of Holding Physical Real Estate in an IRA
You can’t take any deductions for interest paid, expenses, or loss of any kind because the property is already inside a tax-advantaged account.
Historically, investors who understand the risk-return tradeoff of this asset class have built significant net worth. With less than 5 percent of U.S. retirement accounts including real estate of any kind, we feel it is an important piece for our clients to consider in a well-diversified portfolio.
This guide is for informational purposes; neither the information nor any opinion expressed constitutes personal advice. Please consult an expert before changing your personal finances, legal, insurance, or tax plan.
Do you used a self-directed IRA to invest? Why or why not?
Let’s talk in the comments section below.