If you think that there’s money to be made by investing in recently-distressed housing markets, you’re right. But if you think that your IRA investments are limited to stocks, bonds, and mutual funds, you're wrong. Self-directed IRAs can own real estate, too – if it’s done correctly. Here’s what you need to know about safely adding real property to your retirement account.
Opening a self-directed IRA account
Self-directed IRA accounts, as the name implies, are controlled by you! You act as your own account manager. Banks and brokerage companieslimit your choices to things like CDs, stocks, mutual funds, annuities and other products on which they earn commissions. If you want more latitude with your investment choices, you need a custodian that allows self-directed IRAs.
In order to own special assets like rental houses, office buildings or land in a retirement account, you need to work with a firm that offers a self-directed IRA. Many brokerages and other institutions are happy to sell you a regular IRA but don’t care for the extra work of dealing with the self-directed variety. To take advantage of real estate opportunities, then, you might need to switch your accounts to another company.
Many types of IRAs can be converted to self-directed accounts: Traditional IRAs, SEP IRAs, Roth IRAs, 401(k)s, 403(b)s, Coverdell Education Savings (ESA), Qualified Annuities, Profit Sharing Plans, Money Purchase Plans, Government Eligible Deferred Compensation Plans and Keoghs can all be self-directed.
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Your self-directed IRA is required to have a custodian to make sure that your account complies with provisions of the Employee Retirement Income Securities Act. These provisions keep you from having too much fun with your retirement assets – for example, you can’t call your personal wine cellar a “retirement investment” and you can’t get tax bennies from things you use like a vacation cabin or yacht. You can’t use your IRA to funnel tax-free cash to your child by “investing” in his or her startup.
The custodian is there to deal with the reams of paperwork involved and keep you from getting too creative with prohibited transactions.
The real estate purchase
Why would you want to own real estate in your IRA? If you’ve been working for a number of years, chances are pretty good that most of your investment dollars are living in retirement accounts, which give you preferential tax treatment but can limit your investment choices. If that’s the case, the money available for real estate investing may largely be locked up and unavailable for real estate purchases – unless you go the self-directed rout.
Your custodian is not allowed to recommend property for your account, so any bad decisions are your own fault! You’ll probably want the guidance of a skilled real estate agent, attorney, and perhaps an accountant or financial advisor. There are companies that focus on finding real estate for retirement investing. You could also rehab and flip properties in your IRA -- an IRA LLC(definitely have an attorney set this up for you) can make repeated buying and selling easier, and even allow you to add and subtract investment partners.
A mortgage in your IRA?
You are allowed to finance your investment property, but the mortgage must be a non-recourse loan. This means the mortgage lender can’t force you to pay up if you default and the sale of the property doesn't cover the entire outstanding balance. Ask mortgage lenders for non-recourse IRA loans. Understand the mortgage interest rates will likely be higher than those for ordinary purchases because the lender assumes more risk.
Any closing costs owed by you must be paid from IRA funds – it’s illegal to co-mingle your non-IRA money with IRA account assets. Finally, be cautious if considering adjustable rate loans -- if your mortgage payment spikes and your account ends up short of funds, you’re in trouble. A fixed-rate mortgage is much safer for retirement investing.
Rules governing these accounts must be followed perfectly or you could face very stiff penalties. For example, you can use your self-directed IRA to buy your future retirement home, but you can't live in the home before you retire (minimum age 59 ½). You are not allowed to transfer properties that you or your family already own into your IRA. Vacation homes in IRAs cannot be used for your own personal benefit.
Real estate investing is far from fool-proof. If buying property will tie up the majority of your IRA, you could find yourself dangerously under-diversified. Experts advise keeping extra cash in your IRA to cover unexpected expenses, because if you use non-IRA money to repair your property, cover real estate taxes or pay your mortgage, the assets is no longer protected. This is self-dealing if you're under 59 1/2, and the money sheltered by that asset gets taxed as ordinary income and an additional 10% penalty is assessed.
The difference between self-directed IRAs and traditional IRAs is the difference between owning your own company versus buying stock in someone else’s company. You have more control and you can better make use of your own expertise (for example, you know rents and property values in your neighborhood and are positioned to spot a bargain).
However, you have to be the sort of person who relishes taking command and acquiring the opportunity to earn higher returns. According to the SEC, only about two percent of all retirement money is invested in self-directed retirement accounts. If you’re comfortable being the other 98 percent, putting real estate in your IRA is not for you.