Thinking About Buying Real Estate with Your IRA? Read This First

Thinking about buying real estate with your IRA? Read this before you do.

An individual retirement account (IRA) typically offers massive tax-saving benefits while you’re planning for your retirement, like tax-deferred growth or tax-free withdrawals after a certain age—and they can even allow you to lower your taxable income.

So, naturally, just about every personal finance guru will give you the same advice when it comes to withdrawing money from your IRA before retirement: Never do it.

So why is buying real estate with your IRA any different?

First, you’re not actually withdrawing money from the account. If you’re a responsible real estate investor, you can use your IRA in a way that allows you to utilize the account’s tax-saving benefits, potentially saving you thousands, if not tens of thousands, of dollars.

But there are drawbacks (which we'll cover below).

Second, using your IRA to fund a real estate investment isn’t all that different than using your IRA to purchase any other investment, like bonds or shares, but you need to know how to do it responsibly so you don’t end up disqualifying your IRA.

In this article, we’re going to explain how to go about buying real estate with an IRA.

How to Buy Real Estate with a Self-Directed IRA

Using a self-directed IRA for real estate can be a bit more complicated than opening your Vanguard account and buying VTSAX.

Most financial institutions won’t allow real estate investors to use their IRA to purchase real estate, since it doesn’t generate any income for the bank. So, you’ll have two options:

1. “Custodian controlled’ self-directed IRA
2. “Checkbook controlled” self-directed IRA

What is an IRA Custodian?

A custodian is any financial institution that the Internal Revenue Service has approved to take care of an IRA. As we mentioned before, most custodians restrict the use of the IRA for certain investments.

Custodians for self-directed IRAs, though, work differently. The SEC defines self-directed IRAs custodians very succinctly:

“A self-directed IRA is an IRA held by a custodian that allows investment in a broader set of assets than is permitted by most IRA custodians.  Custodians for self-directed IRAs disclaim most duties to investors, and may allow investors to invest retirement funds in “alternative assets.’”

What does this all mean in layman’s terms? If you want to set up a self-directed IRA for real estate, you have to go with a bank that’s going to allow you to do that.

What is a Checkbook-Controlled IRA?

On the other hand, if you go with a checkbook-controlled IRA, you’re setting up a real estate IRA LLC for, of course, the purpose of buying and holding your real estate, and then you’re using the funds from your IRA to invest in that LLC, which is then investing in the property you wish to purchase.

In this case, the IRA needs 100% ownership over the LLC, but it opens up the possibility for making quick cash deals using the money in your IRA.

Can an IRA Be Held in a Brokerage Account?

Since we’re on the topic of alternative investments that you can make with your IRA, you might be wondering, “Can an IRA be held in a traditional brokerage account?”

The simple answer is yes. You can hold an IRA in a brokerage account, but the IRA is its own account. Most of the time, when you open a brokerage account—or any additional account within your current brokerage—they’ll typically ask you whether or not you want to open it as a traditional (taxed) account or a tax-deferred IRA (or a Roth, or SEP, or any of the other types of IRAs).

6 Things to Keep in Mind While Using a Self-Directed IRA to Buy Real Estate

Finally, here are some important things to keep in mind if you’re interested in using an IRA to buy a property:

1. You can’t mortgage a property using the funds in your IRA. Since you can’t borrow money against your IRA, you’ll need to make the purchase in cash using the funds that you have available.
2. Your IRA needs to be large enough to cover the investment’s ongoing expenses. Not only do you need enough money to cover the down payment and closing costs, but you also need to make sure you have enough money in the IRA to keep running the business before it starts generating income itself (if ever). Crunch the numbers on the property taxes, special assessments, HOA fees, home insurance, and maintenance. Make sure you have enough stashed away in the IRA to cover those costs.  
3. You can’t personally use the investment. If you’re looking to use your IRA to purchase a primary residence (or a vacation home or anything for your relatives), you’re out of luck. It needs to be strictly arm’s length, and you can’t receive any direct or indirect benefit from it.
4. You can’t withdraw any of the gains from your IRA until you’re 59.5 years old without incurring penalties—and that number may go higher in the coming years.
5. As soon as you reach 70.5 years old, you’re required to start taking required minimum distributions regardless of whether or not you need them (unless your IRA is a Roth). This could cause you to sell your IRA-funded property in a down market.
6. If you break any of the IRS’s rules on managing your IRA, you subject the entire IRA to taxation.

The Takeaway

In this article, we examined the relationship between the IRA and real estate. This includes opening up a self-directed IRA with a custodian (a financial institution) that will allow you to use the IRA for “alternative investments” and to set up a real estate IRA LLC so that you can then buy that LLC through your IRA, which is known as a “checkbook-controlled IRA.”

Sometimes it might sound like a bunch of alphabet soup, but if you’re an experienced real estate investor who doesn’t need access to the gains until you’re past 60 or so, you can save a bundle on your tax bill by using your IRA to fund your real estate investment. It’s really no different than using your IRA to fund any other investment, it’s just a bit different than what most investors use the account to do.

Remember, though, there are some drawbacks. First off, depending on the real estate you’re looking at, you’ll need quite a bit of money inside the IRA to start, and this can take some time to build up. Second, you can’t use the property yourself, or for your relatives. Finally, if you break any of the IRS’s rules, you could possibly subject your entire IRA to taxation, so make sure you know what you’re doing by working with an experienced professional.