Can I Use an IRA to Buy Investment Property?

Individual Retirement Accounts (IRAs) are tools for building retirement savings, offering tax advantages. A common question is whether these accounts can be used for tangible assets like investment properties. Yes, an IRA can be used to purchase investment property, but this requires a specific type of IRA and adherence to regulations.

The Self-Directed IRA Vehicle

To invest in real estate or other alternative assets, individuals use a specialized account known as a self-directed IRA (SDIRA). Unlike conventional IRAs, which limit investment choices to publicly traded securities, an SDIRA provides a broader range of permissible investments. This flexibility allows account holders to diversify their retirement portfolios.

An SDIRA requires a custodian or trustee, a financial institution approved by the IRS. This entity holds account assets and facilitates investment transactions. The account holder directs investments, while the custodian maintains legal custody of funds and property. The custodian ensures adherence to IRS rules and reporting requirements, but does not offer investment advice or conduct due diligence.

Permitted and Prohibited Assets

An SDIRA can hold diverse real estate types as investments. These include:
Residential properties like single-family homes, multi-family units, condominiums, and rental properties.
Commercial properties like office buildings, warehouses, and retail spaces.
Raw land, farmland, and fix-and-flip properties.

Properties must be acquired and held solely for investment purposes, generating income or appreciation.

Certain assets are prohibited from being held within any IRA, including SDIRAs. These include:
Collectibles such as works of art, rugs, antiques, most gems, stamps, certain coins, and alcoholic beverages.
Life insurance policies and S-corporation stock.

A restriction for real estate investments is the prohibition of personal use or benefit by the IRA owner or any disqualified person. The property cannot serve as a primary residence, vacation home, or be used for personal enjoyment.

Understanding Key Compliance Rules

Investing in real estate through an SDIRA requires understanding IRS compliance rules, especially those preventing self-dealing and conflicts of interest. A central concept is the “disqualified person,” as defined under Internal Revenue Code Section 4975. This category includes:
The IRA owner, their spouse, ancestors (parents, grandparents), and lineal descendants (children, grandchildren) and their spouses.
Any entity in which the IRA owner or other disqualified persons hold a 50% or greater interest.

Prohibited transactions involve direct or indirect dealing between the IRA and a disqualified person. Examples include:
Buying property from or selling property to a disqualified person.
Using the IRA-owned property for personal benefit, such as living in it or vacationing there.
Personally performing services for the property, such as repairs or management.
Lending money to or borrowing money from a disqualified person.

Violating these rules can disqualify the IRA, resulting in immediate taxation of its full value and potential penalties.

Another consideration for SDIRA real estate is Unrelated Business Taxable Income (UBTI) and Unrelated Debt-Financed Income (UDFI). UDFI is triggered when an IRA uses borrowed money (leverage or a mortgage) to acquire or improve real estate. Income generated by the debt-financed portion of the property is subject to UBTI tax at trust tax rates. This tax liability applies even if the IRA is tax-exempt or tax-deferred, and the IRA owner is responsible for calculating and reporting this income.

Acquiring and Managing Property Through an SDIRA

Investing in real estate through an SDIRA begins with selecting a specialized custodian. Not all IRA custodians handle alternative assets, so choose one with real estate expertise. These custodians manage administrative and compliance requirements for real estate transactions.

After choosing a custodian, the SDIRA must be funded through direct contributions, transfers from existing IRAs, or rollovers from employer-sponsored retirement plans. After funding, the account holder identifies a property and directs the custodian to initiate purchase. All acquisition funds, including earnest money and closing costs, must flow directly from the SDIRA through the custodian. The property’s title must be held in the SDIRA’s name, for the benefit of the IRA holder, not personally.

Ongoing property management adheres to strict SDIRA rules. All property expenses, such as taxes, insurance, maintenance, and repairs, must be paid directly from SDIRA funds. All income generated by the property, including rental payments, must be deposited into the SDIRA. The IRA holder cannot personally perform services or use personal funds for expenses, as this is a prohibited transaction.

Tax Treatment of SDIRA Real Estate

Tax treatment of real estate within an SDIRA mirrors other IRA investments, depending on whether it is a Traditional or Roth SDIRA. For a Traditional SDIRA, income from the property, such as rental income and capital gains, grows tax-deferred. Taxes are deferred until distributions are taken in retirement, then taxed as ordinary income.

A Roth SDIRA is funded with after-tax dollars; contributions are not tax-deductible. All qualifying distributions in retirement, including growth from real estate investments, are entirely tax-free. This is beneficial if the property appreciates or generates significant rental income. Typical real estate deductions, such as depreciation or operating expenses, are not claimed on personal tax returns while the property is held within the IRA. Tax benefits are realized at distribution, not during the holding period. If the property is debt-financed, Unrelated Debt-Financed Income (UDFI) may still be subject to tax, even within a tax-advantaged SDIRA.