Can I Buy Rental Property With My Roth IRA?

Investing in real estate through a Roth IRA offers an opportunity to grow wealth with significant tax advantages. Unlike many retirement accounts that limit investments to traditional assets, a Roth IRA can hold alternative assets like rental properties. This strategy allows potential rental income and property appreciation to accumulate tax-free, with qualified distributions in retirement also tax-free. Navigating this path requires careful adherence to specific IRS rules to maintain the Roth IRA’s tax-advantaged status.

Establishing a Self-Directed Roth IRA for Real Estate

Investing in real estate with a Roth IRA necessitates a self-directed IRA (SDIRA). An SDIRA expands investment options to include alternative assets like real estate, precious metals, and private equity. This flexibility comes with increased responsibility for the account holder to understand and comply with IRS guidelines.

A self-directed IRA custodian plays a central role, acting as the administrator and record-keeper for the account. The custodian holds the assets, processes transactions, and ensures compliance with IRS regulations, but does not provide investment advice. The IRA itself, not the individual, is the legal owner of any real estate purchased through the SDIRA. When selecting a custodian, consider their fee structure and the types of investments they handle.

Opening a self-directed Roth IRA involves contacting a specialized custodian and completing an account application. Funds can be contributed directly, or existing Roth IRA funds can be rolled over or transferred from another retirement account. For instance, a Roth 401(k) can be rolled into a self-directed Roth IRA, or a traditional IRA can be converted, though conversions may be subject to income tax. Once established and funded, the SDIRA can then be used to acquire rental properties, with all transactions executed by the custodian at the direction of the IRA owner.

IRS Prohibited Transactions and Disqualified Persons

The IRS imposes strict rules on self-directed IRAs to prevent “prohibited transactions,” which are improper uses of IRA assets that directly or indirectly benefit the IRA owner or “disqualified persons.” These rules ensure retirement funds are used solely for retirement savings, not for personal gain or self-dealing. Engaging in a prohibited transaction can lead to the disqualification of the entire IRA, making all assets taxable as of the beginning of the year the transaction occurred, and potentially a 10% early withdrawal penalty if the owner is under age 59½.

A “disqualified person” includes the IRA owner, their spouse, and certain lineal relatives such as parents, grandparents, children, grandchildren, and their spouses. It also extends to any entity in which the IRA owner or other disqualified persons hold a 50% or greater interest. Anyone providing services to the IRA, such as the custodian or an investment advisor, can also be considered a disqualified person.

Common prohibited transactions relevant to real estate include selling, exchanging, or leasing property between the IRA and a disqualified person. For example, an IRA cannot purchase a property from the IRA owner or their spouse. Lending money or extending credit between the IRA and a disqualified person is also forbidden. This means the IRA cannot lend money to the IRA owner, nor can the IRA owner personally guarantee a loan for an IRA-owned property.

Furnishing goods, services, or facilities between the IRA and a disqualified person is another restriction. The IRA owner cannot personally manage the rental property, perform repairs, or provide any services to the property, as this constitutes providing services to the IRA. Using IRA assets for the personal benefit of the IRA holder or a disqualified person, such as living in the rental property or using it for personal storage, is also prohibited.

Administering Your Roth IRA Rental Property

Once a rental property is acquired within a Roth IRA, all financial transactions must flow exclusively through the IRA account, managed by the custodian. All income generated by the property, such as rent payments and security deposits, must be deposited directly into the Roth IRA. This ensures the tax-free growth advantages of the Roth IRA are maintained. Similarly, all expenses associated with the property, including property taxes, insurance premiums, maintenance costs, repairs, and property management fees, must be paid directly from the Roth IRA account. The IRA owner cannot pay for these expenses out of personal funds, as this would be a prohibited transaction.

To avoid prohibited transactions, the IRA owner cannot personally perform services or “sweat equity” on the property. Instead, all services related to the property, such as property management, repairs, and maintenance, must be performed by independent third-party professionals. The IRA owner should engage and pay these professionals through the IRA custodian. This separation ensures the IRA owner does not receive any direct or indirect personal benefit from the property beyond the tax-free growth of their retirement account.

The IRA owner is also prohibited from using the property for any personal purpose, including as a personal residence, a vacation home, or for storage. The property must be held purely for investment purposes. Record-keeping is important to demonstrate compliance with IRS rules. While the custodian maintains records, the IRA owner is responsible for ensuring all transactions are properly documented and the property remains compliant with investment-only guidelines.

Unrelated Business Taxable Income (UBIT)

Even with a Roth IRA, which generally offers tax-free growth and distributions, certain types of income can be subject to Unrelated Business Taxable Income (UBIT). UBIT applies to income derived from a trade or business regularly carried on by a tax-exempt organization, including IRAs, if that business is not substantially related to its exempt purpose. While passive investment income like rents and capital gains from real estate typically are not subject to UBIT, specific scenarios can trigger this tax.

For IRA-owned real estate, UBIT most commonly arises from Unrelated Debt-Financed Income (UDFI). UDFI occurs when an IRA uses borrowed money, such as a mortgage, to acquire or improve a rental property. If a portion of the property’s purchase is financed with debt, then a proportional share of the net rental income and any capital gains from its sale becomes taxable as UBIT. For instance, if an IRA purchases a property with 40% borrowed funds, 40% of the net income generated by that property would be considered UDFI and subject to UBIT. This tax liability exists even for Roth IRAs, potentially eroding the otherwise tax-free growth.

The tax payment is made from the IRA’s funds, not the IRA owner’s personal funds. While UBIT can reduce the tax-free benefits of a Roth IRA, it does not necessarily negate the overall advantages of real estate investment within the account, especially if the property generates substantial income or appreciation.