Taxes. That simple word makes many of us cringe. We all have a silent partner named Uncle Sam who takes a nice chunk out of every dollar we earn. We have no choice — we have to pay this partner or bad things will happen to us. We can, however, legally shelter some of that income from our silent partner. One way we can do that is to use a self-directed IRA.
An IRA is an individual retirement account. And almost all of us who have ever worked a regular job have heard of this and at some point had the ability to open an IRA (or a 401K plan, which is similar) through our employer. The IRA was developed as a tool to help people save for retirement. It generally works like this. You deposit a bit of your paycheck every month into an IRA and those funds are then invested and hopefully grow to provide for your later years. To encourage folks to use this tool and save for their retirement, Uncle Sam instituted several IRA income tax incentives. These incentives include the ability to shelter some of your hard earned income and the possibility of tax-free income.
You do not, however, have to be employed in a full-time job or work for a big company to enjoy the benefits of an IRA. Self-employed real estate investors can also get in on the tax benefits of having an IRA. Every individual or small business owner has access to what are called self directed IRAs. And these self-directed IRAs can be a great wealth building tool.
By controlling what the IRA invests in.
How to Invest in Real Estate While Working a Full-Time Job
Many investors think that they need to quit their job to get started in real estate. Not true! Many investors successfully build large portfolios over the years while enjoying the stability of their full-time job. If that’s something you are interested in, then this investor’s story of how he built a real estate business while keeping his 9-5 might be helpful.
What Exactly is a Self-Directed IRA?
That is the difference between an IRA offered by a large employer and a self-directed IRA that you set up. You control what the IRA invest in. Generally, in an employer-sponsored IRA, you will have a limited number of investment options to choose from. These options usually include stocks, bonds, mutual funds, or even certificates of deposit for the risk averse. Further, your options may even be limited to a particular brand of funds depending on who the custodian of the IRA is. Think Fidelity or Ameritrade here.
With a self-directed IRA, however, you direct how the funds are to be invested (hence the name). Thus, the options available to you are wide open (with certain limitations). Not only can you invest in stocks, bonds and mutual funds, but you can also invest in real estate, options and notes to just name a few. In fact, your options are almost unlimited as to what you can invest in. It is up to you and your creativity to find the best and most profitable investments.
And here is the best part; the growth of the investments in your IRA is tax deferred. If you set up a Roth IRA, the growth is tax-free. Think about that. If you invest in a $50,000 property and sell it for $250,000, that growth could be tax-free. If you own a rental property for 20 years and deposit the rental income in your IRA that rental income is not taxed. You can lend hard money and the interest and points you earn may not be taxed. You can also shelter some of your income by depositing the maximum $5,500 ($6,500 if you are over 50) into your account every year.
Sounds great, right? There are, however, some catches.
5 Restrictions of Self-Directed IRAs
There are income limitations.
Uncle Sam will not let high income earners open these accounts. That is usually OK for the average or new real estate investor. But the best advice is set one up now before all of that real estate wealth comes rolling in.
You cannot have material benefit from any of the funds or investments in your self-directed IRA.
That means, for example, if you are a real estate agent and buy a property to put in your IRA, you cannot take a commission. You also cannot pay yourself to manage your IRA’s investments, nor can you live in a property owned by your IRA. Basically, you can’t benefit from the IRA until you retire.
You cannot materially participate in the maintenance of your IRA’s investments.
This can be a tricky one. This means, for example, that you cannot do anything to maintain that rental property in your IRA. You cannot cut the grass. You cannot change a light bulb. You can’t paint, fix up, or repair anything on any property in your IRA. If you do and get caught, you could cause your IRA to lose its status and thus be forces to pay both taxes that would have been owed along with penalties and interest. Instead, you have to hire someone to do anything and everything for you and pay them with funds directly out of your IRA. This can get a bit complicated at times because there are numerous forms to be filled out and time involved in receiving the payments.
You also have to set up the IRA through a proper custodian.
You cannot just go to any bank and open one. There are many custodians out there. They are the folks that will actually hold title to property your IRA buys. They will hold it for your benefit.
You lose the benefits of depreciation.
If you hold real estate in your IRA, you do not get to take the benefits of depreciation to offset other income you may have. However, as I said, you do get the potential benefits of tax-free income and the offset of any IRA contributions.
Self-Directed IRA Q&As
How much can I contribute per year?
You can contribute up to $5,500 ($6,500 if you are over 50) per year of your earned income. Remember that rental income is passive income, so if that is all of the income you have (as I once did), you cannot contribute anything. This can be a great resource for flippers who get hit with that daunting self-employment tax.
Can I get loans in my IRA?
Yes, you can, but you may have a tough time finding someone who will loan to your IRA. Still, there are companies and people out there who will do it. You may also be faced with something called UBIT or Unrelated Business Income Taxes that may or may not make an investment feasible. Talk to your tax advisor on this issue.
Can anyone set one up?
Yes, as long as you meet the income requirements. Talk with your tax advisor to be sure.
Can you co-mingle IRA funds with other investors?
Yes. My wife and I do this on investments we own.
Can I transfer funds from other IRAs into my self directed IRA?
Yes, as long as you have a qualifying event, which is generally separation from a job. If you quit your job, you can usually transfer IRA funds to your self-directed IRA. Just be careful you follow the rules when doing so, and do not expect it to be easy. Your existing IRA custodians will not want to let you go.
Can I have a checkbook and use an LLC in my self-directed IRA?
I have heard good and bad about these two issues, and honestly, these are gray areas. Some custodians will steer you away from these, and others will help set them up. Thing is, we do not know if they are completely legal, as there have been few if any court cases to clarify the law. So if you set one of these up, please tread carefully.
I have found my self-directed IRA to be a pretty good wealth building tool, especially since I was able to consolidate several smaller IRA and 401K plans into it after I quit my full-time job. I can easily see how having this account is really going to pay great dividends as I get older.
Any questions about self-directed IRAs?
Leave your comments below!