Thinking about rental properties using Self Directed IRA.

27 Replies

My first post to BP.  Posted the same to Reddit but think there might be some different opinions here.

I've currently got an IRA with Betterment that has around 180K. I've been looking at RE Investing as an option to get my money out of the stock market. I currently have a full time job where I receive pretty decent bonuses and RSU's so long term I'd like to use that income for RE investing but it will probably be at least a year or two before I can do that because I'll probably use that income this year to buy a house for my family.

So short term my idea was to move the money in my Betterment account to a self directed IRA. I then was planning to use the self directed IRA to buy property through Roofstock. Since this will be my first real estate I am trying to do it fairly hands off and the local real estate market where I am doesn't appear great for cheaper rental properties.

As part of this plan I suppose I'd have a couple options. 1) Buy one or two properties using cash from the self directed IRA. 2) Financing 3-4 properties using funds from the self directed IRA. Because I'm new to all of this I tend to favor option one. The other nice thing about that is that I wouldn't have to worry about mortgage payments. I know that having multiple properties through financing has it's benefits in a normal scenario but from what I've read I could have some issues with UBIT if I do that since I'd be using a self directed IRA.

So having said all this does it make sense to move my money out of Betterment and use it for rental property investing? Is it a good idea to use Roofstock especially considering I want to stay fairly hands off and I don't have great property options locally? Should I just wait until I can start doing rental property investing with cash on hand? I do have a couple meetings set up with local CPA's to see what they recommend and I also will be speaking with Roofstock soon to learn more about them as well. I figured I would check with you all though as well to get any advice you have to offer because I know there is a lot of expertise here.

Thanks in advance for all your assistance.

Eric,
You are going to get tons of different answers and opinions on this, so I would definitely do your own homework and education. Being a CPA, I would advise against rental properties in an IRA. You are putting a tax shelter inside a tax shelter.

For rental properties, I would just use cash and then refinance or use bank leverage in the first place. This is a lot more easier than in an IRA and you get to use the cash flow now while still paying no tax. Read the book “Tax Free Wealth” by Tom Wheelwright before you make any decisions.

Thanks!

@Mark Welp Thanks for the response. I'd love to use cash to pay for rentals but I don't currently have 80k-120K in cash to do that. That's why I was thinking of using a self directed IRA for the purpose. I buy the properties outright and then earn retirement income from the rent-expenses. Plus I'd have the additional benefit of potential appreciation later if I decided to sale the properties. I have 20 years before I can start withdrawing funds from an IRA no matter if it's with Betterment or a Self Directed IRA. The reason I'm thinking about rental property is because I'd like to have more control over my retirement money than I do with it locked up with Betterment.

Eric,
Makes sense. I would still recommend that book if you have not read it. Tom Wheelwright is a pretty smart guy.

If you have any questions or need any tax guidance, let me know. Thanks,

@Eric Schwake

@Mark Welp is technically correct that real estate outside of an IRA is fairly well tax sheltered. It is an argument we hear often here on BP that, honestly, misses the mark for most investors.

Your question is not, should I invest in real estate with cash or with an IRA, but rather; "I have an IRA and am considering whether investing it in real estate may be better than leaving it in the stock market?". As such, whether real estate may or may not be more efficient with after tax money that you noted you do not have, is not really relevant.

Real estate can be an excellent retirement asset.  The principal is secure and less volatile than other common retirement assets.  Real estate has the potential to produce income both via appreciation and cash flow.  And once can use leverage when investing in real estate... not something that would be wise in the stock market.

I cannot speak to Roofstock specifically.  A turnkey real estate opportunity will generally water down your return somewhat, but that cost is a trade-off for leveraging the expertise of a professional real estate asset manager.  Managing your own properties can be a steep learning curve.

The tax on leveraged real estate is not a deal killer at all. The cost of UDFI taxation on leveraged real estate in an IRA is typically nominal, and will only slightly reduce the benefits of leverage. A leveraged property in an IRA should still generate significantly higher cash-on-cash return than an all cash purchase. It is, admittedly, a more complex strategy with the attendant risk of having that mortgage payment to cover whether the property is rented or not. One option is to start all cash and then bring leverage to bear later, either when purchasing additional properties or by cashing out some of the equity in the all cash property to facilitate the purchase of additional property.

So, continue to do your homework on Roofstock or other turnkey providers. If you think the overall mix of risk/reward for the IRA will produce better long term results that leaving all of the IRA money in the stock market, then take a closer look at the self-directed IRA options to facilitate such an investment.

Nicole,

That is great. I am just advising to do your homework before you place a hard physical piece of real estate inside an IRA. Self Directed IRA's are really pushed on this website, and they are great tax savings vehicles for certain items like real estate notes. Notes do not have a lot of tax benefits by themselves, so placing them inside an IRA is great! But rental properties are different. When you have rental properties inside an IRA, you cannot take depreciation. Depreciation is one of the most single best benefits of rental properties. It is a non-cash loss! How great is that.

Again, read the book first and then make the decision. I would never advise any of my CPA clients to put rental properties inside an IRA. Thanks!

@Brian Eastman Thanks for you response. I've already been looking into IRA custodians and have read pretty much your whole page so expect to hear from me on that soon. You mention UDFI not being a major concern but what about UDIT if I decided to finance? I've heard that can cut into returns when financing through a self directed IRA which is primarily why I'd been thinking of a cash purchase. In a year or two I plan to use income received from sources such as my employer bonus and RSU stock sales and at that time I'd definitely be looking into financing.

@Mark Welp Funny you mention notes because I just listed to BP podcast number 211 that spoke about investing in notes and it sounded intriguing.  Those seem a bit more confusing and harder to get into that rental properties but I need to do more research.  It looks like there is a newer podcast (#273) that goes into notes more so I'll have a listen to that.

@Eric Schwake

When an IRA uses leverage, the percentage of the income derived from the non-IRA (borrowed) money is taxed as Unrelated Debt-Financed Income, or UDFI.

$200K leveraged to purchase $400K in property might create a tax bill of about $500-600/year.  This is a very small cost for the additional return that will result.  There is a UDFI calculator in our website Learning Center you can use to run some scenarios and compare a leveraged investment to an all cash investment.

@Brian Eastman

Wouldn't UBIT also apply to a self directed IRA if I financed a home or would I have UBIT no matter if I finance or pay cash? I was under the impression I'd only have UBIT for financing. The other reason I was thinking about cash only is because perhaps some sellers would be more willing to give a better price if I offered cash rather than financing.

I recently went through a similar decision making process. Ultimately I decided against it. I, however did not have nearly enough to purchase several properties outright; I would have needed financing. The major drawbacks to me were the loss of depreciation as well as any other losses wouldn't be able to offset gains from my other traditional rental properties. I also manage my own so it would be a very hard line for me to toe by not doing any of the work myself. Not that I pay myself as it is now but just getting the funds to make repairs would be an extra hassle. I did briefly consider a self direct IRA LLC to circumvent that issue but it just brought on a whole host of other issues.

After speaking with a CPA I actually ended up buying a life insurance policy with it that will pay me a pretty decent annuity once I retire. I am still relatively young and the only life insurance I had was through my company so I wanted something in case I lost my job. Now I did have to take it out of the IRA to do this but the policy basically gave me a loan to cover the taxes. I just plan to fund real estate in more conventional ways that I have better control over.

Eric,

I have used a self directed IRA to purchase two condos. I would recommend you read, "The Self Directed IRA Handbook" by Matt Sorensen. Easy read, easy to understand. There are certain rules the IRS has for holding real estate in your IRA. I also had the author Matt Sorensen ( he is an attorney) set up my LLC for the IRA, per IRS rules.

I live in an area of appreciation more than cash flow so in the three years of owning these condos their value has doubled. This is tax free if I choose to sell and capture the equity. These are my first rentals, I'm a newbie, I wanted to own real estate and I didn't have the cash to purchase them even with a loan so I choose this route. So far I have been very happy with using the IRA.

I don't know if getting mortgages on these properties so I could claim depreciation would have been a better option but as I said I didn't have the cash to go that route. So the IRA was what I choose.

Good Luck with whatever route you choose.

@Eric Schwake

UDFI is the type of income subject to tax when an IRA uses debt-financing. It is a form of income through which the tax due is paid as Unrelated Business Income Tax or UBIT. I am simply using more precise language.

I do this because Unrelated Business Taxable Income (UBTI) is generated when a tax-exempt entity engages in a trade or business on a regular or repeated basis (i.e. flipping houses or other types of dealer activities).  This type of taxation can be a real deal-killer in many cases.

Rental income is passive and therefore not considered UBTI.  Debt-financed rental income generates taxable UDFI.

BTW, notes are also a great option for diversifying tax-sheltered retirement savings into a more stable asset class than equities. Unlike real estate, however, notes typically do not appreciate in value and one cannot use leverage in most cases to acquire notes. So, it is possible with the right rental real estate to out-perform the returns of notes. Those who make blanket statements that they would never put real estate in an IRA are getting caught up with tax-theory purity and not looking at the actual numbers - which is what really matters.

@Robyn Green

Great suggestion. I'll be buying that book and adding it to my reading list.  I'm already half way through 'Build a Rental Property Empire' but he's definitely not going to go into the ins and outs of self directed IRAs in that book. 

I was thinking about an LLC but still not totally sure if I'll get one. Maybe reading that book will convince me to. Is there a reason you used him to make your LLC? Are you comfortable to tell me his rate for doing so either here or on private message?

Originally posted by @Eric Schwake :

My first post to BP.  Posted the same to Reddit but think there might be some different opinions here.

I've currently got an IRA with Betterment that has around 180K. I've been looking at RE Investing as an option to get my money out of the stock market. I currently have a full time job where I receive pretty decent bonuses and RSU's so long term I'd like to use that income for RE investing but it will probably be at least a year or two before I can do that because I'll probably use that income this year to buy a house for my family.

So short term my idea was to move the money in my Betterment account to a self directed IRA. I then was planning to use the self directed IRA to buy property through Roofstock. Since this will be my first real estate I am trying to do it fairly hands off and the local real estate market where I am doesn't appear great for cheaper rental properties.

As part of this plan I suppose I'd have a couple options. 1) Buy one or two properties using cash from the self directed IRA. 2) Financing 3-4 properties using funds from the self directed IRA. Because I'm new to all of this I tend to favor option one. The other nice thing about that is that I wouldn't have to worry about mortgage payments. I know that having multiple properties through financing has it's benefits in a normal scenario but from what I've read I could have some issues with UBIT if I do that since I'd be using a self directed IRA.

So having said all this does it make sense to move my money out of Betterment and use it for rental property investing? Is it a good idea to use Roofstock especially considering I want to stay fairly hands off and I don't have great property options locally? Should I just wait until I can start doing rental property investing with cash on hand? I do have a couple meetings set up with local CPA's to see what they recommend and I also will be speaking with Roofstock soon to learn more about them as well. I figured I would check with you all though as well to get any advice you have to offer because I know there is a lot of expertise here.

Thanks in advance for all your assistance.

 It seems this is becoming more popular. Have you contacted Equity Trust? They do a lot in this area.

Hi Eric, welcome to BP. As evidenced, there is a lot to consider. I'm also looking to invest a portion of my IRA funds in real estate and, based on my research, below are some clarifying points.

1. What is taxed?  Keep in mind, the only part of net income that is taxable is the portion financed.  If you finance 50% of the property (with a non-recourse loan), then 50% of the NET profit is taxed after you deduct all expenses and, yes, depreciation from the portion you financed. True, you can't take depreciation for IRA funds used, but you can realize depreciation on the portion financed - which reduces the income subject to taxation. Also, as Brian notes, the tax is pretty low. It's based on the Trust Tax Schedule (which for 2018, looks to be 10% for net income $0-$2500; then 24% between $2501-$9150 etc.) Example: If your property grosses $10,000 and after all deductions (taxes, insurance, repairs, expenses, depreciation) you end up with a net income of $2500, the Unrelated Debt Financed Income (UDFI) portion is 50% or $1250 -- so the tax would be $120.

2. No depreciation in an IRA? True for your IRA funded portion only. For the IRA money used, I grappled with this a bit, but in thinking it through, who cares? We like depreciation because it provides an offset to our taxable income -- so we pay less taxes (assuming your income isn't too high in which case losses are deferred). But if you're in an IRA, all the income made from real estate goes back into the IRA -- so I don't think we lose anything. I'm not paying taxes on any income the IRA generates, so who cares if we can't depreciate? Also even in non-IRA scenarios, we make up the depreciation on the other end (it gets added to cost basis). Playing it out, we retire, start taking distributions from the IRA, the property is paid off (or not), and all the income that's been accumulating over the years is sitting there -- still accumulating from rents coming in. Depending on whether it's a Roth or Traditional IRA, you pay taxes on withdrawals, but you would do this regardless of the IRA investment vehicle.

I love this because unlike the commercials that scare you with asking how long your money will last into retirement, with real estate you have a living entity that generates income as you take it out.  So live to 100 and not worry!  Of course good dividend stocks can also provide income, so good to diversify.   I agree with Brian's point that it boils down to where you want to invest your retirement savings. 

I'm still learning, but it helped to write this out.  I hope it was of some use.   There are some great resources here - https://www.trustetc.com/self-directed-ira/rules/ubit

@Eric Schwake You've already received a ton of great advise from @Brian Eastman and clarification from @Robyn Green

I'd like to give you food for thought about a few more items. 

When it comes to notes, it doesn't have to be complicated. You can become the bank within your IRA and lend others money for a fixed rate. You can do it on your own, or through hard money lenders or through real estate companies.

Another option to consider if you're looking to be engaged very little with your investment is to invest in the commercial real estate through a syndication. Yes, it will incur UBTI. However it will not happen at first until an asset is  fully depreciated. And as was mentioned above won't be significant. This type of investment is completely hands off. However you'd have to educate yourself first in the field.

I have personally gone through SDIRA with a custodian, checkbook IRA and solo 401k. So happy to share my experiences. Feel free to PM if you have questions.

Best!

@Lynne Smith @Alina Trigub

Thanks for both of your responses.  I think at this point I'm looking at a few options on how to proceed with SDIRA funds.

1) Buy a single property with cash.  This seems fairly safe in that even if I have tenants miss rent I won't have to worry about covering the missed mortgage payments.  After I've got one under my belt depending on funds left I'll either keep it in the stock market or maybe do financing for a second property.

2) Finance between 2 and 3 properties. This provides me some diversity but also more risk because I'd have to have funds always available in the IRA to pay for missed rents.

3) Buy 2-3 performing notes.  This seems fairly low risk but I still need to do more research into note options.  @Alina Trigub  look for a PM from me :).

4) Buy a note and a property either with cash or financing depending on my funds available.  

Thanks for everyone's feedback on this.  Obviously since this money is what I'm going to be using for my retirement I want to make sure I've done all my research before making a move one way or another. 

@Eric Schwake

Diversifying your nest egg into real estate is a good option in my view. Obviously, I don't recommend putting all your eggs in one basket. If you don't already hold real estate in your IRA then consider investing a percentage of it in rental real estate.

@Eric Schwake

The IRS says you have to form an LLC to buy real estate in the self directed IRA.

I heard Matt speak at a real estate club meeting, I bought and read his book and decided since he knew what he was doing I would hire him.  I don't remember what he charges but you can call his office and get a price.  

I was nervous since it was my first deal and I was dealing with the IRS (come on they are a little scary) so I wanted to make sure EVERYTHING was done by the book.  So far no problems as long as you follow their rules.

Here's what I was thinking about my initial foray into this. Let me know what you think.

I will move $100K into a SDIRA with checkbook control. Of this I will look for a rental property between $65K-$70K. I will buy that property with cash. I'd like to keep 10% of the purchase price of the property fairly liquid within the IRA for emergency funds for the rental which is ~$7K. So on the high end this leaves ~$20k in the SDIRA (factoring in funds required for setting up the SDIRA). I'd like to use those funds to look at buying performing notes. I'm not quite sure if $20k is really enough to buy a performing note. However since I've purchased the rental with cash am I able to use the equity in that to help purchase a note? I'm not quite sure how using the equity in the property would work.

@Eric Schwake ,

You can't use equity in the house that you own free and clear to buy a note (or any other investment), you would have to do cash our refinance to pull the cash and then use that to invest.

$20K is definitely on the low side so your options for fining a note in this price range will be limited, but it is not possible, there are some out there... just be sure to do your due diligence and make sure that the underlying property is not a piece of crap, be prepared to foreclose in a case of a default and become the owner of that property. If you are OK with that then invest, there is always likelihood of a default for you as a lender. 

@Dmitriy Fomichenko  

So basically if I paid 70k cash for a house I could turn around the next day and do a cash out refinance and pull out $30k which would allow me to spend $50k on a note?  I've never done a cash out refinance so not sure exactly how it works.  Also not sure if it's treated differently within an SDIRA but I don't think it is