Can I Use My IRA to Buy an Investment Property?

It is possible to use funds held within an Individual Retirement Account (IRA) to acquire investment property. While traditional IRAs limit investment options to common assets, certain types of IRAs offer the flexibility to invest in alternative assets, including real estate. Navigating this strategy requires understanding the unique rules and potential tax implications to ensure compliance and avoid penalties. This approach allows individuals to diversify their retirement portfolios and potentially benefit from real estate appreciation and income.

Understanding Self-Directed IRAs and the Investment Process

Investing in real estate through an IRA involves a Self-Directed IRA (SDIRA). An SDIRA allows for a broader range of alternative investments, such as real estate, private equity, and precious metals, providing greater flexibility than standard brokerage IRAs. The fundamental difference lies in the account holder’s ability to direct investment decisions for assets beyond publicly traded securities.

An SDIRA requires an IRS-approved custodian or trustee. This entity is responsible for holding assets, processing transactions, and ensuring compliance with IRS regulations. The custodian acts as a passive administrator, handling administrative duties and reporting requirements. All funds and expenses related to the real estate investment must flow through the SDIRA and be managed by the custodian.

The process of acquiring real estate with an SDIRA begins with funding the account, typically through transfers from other retirement accounts or annual contributions. Once funded, the account holder identifies a suitable investment property. The SDIRA custodian then facilitates the purchase, ensuring the property is titled in the name of the IRA, not the individual. All income generated by the property, such as rental payments, must be directed back into the SDIRA, and all expenses, including property taxes, maintenance, and insurance, must be paid directly from the SDIRA’s funds.

A common structure for real estate investing with an SDIRA is the “IRA LLC” or “checkbook control” arrangement. In this setup, the SDIRA invests in and owns a Limited Liability Company (LLC). The IRA holder can then serve as the manager of this LLC, providing more direct control over investment decisions and the ability to execute transactions directly from the LLC’s bank account without requiring custodian approval. While this structure offers increased speed and control, the IRA still owns the LLC, and all real estate assets remain subject to strict IRA rules and prohibited transaction guidelines. The LLC acts as a pass-through entity, with all income and expenses ultimately attributed to the SDIRA.

Investment Rules and Prohibited Transactions

Strict IRS rules govern investments within a Self-Directed IRA, especially concerning real estate, to prevent self-dealing and ensure the IRA serves solely for retirement savings. Internal Revenue Code Section 4975 defines the boundaries of permissible actions. Understanding these rules is important to maintain the tax-advantaged status of the retirement account.

Allowable real estate investments within an SDIRA are broad and include various property types. These can encompass:

• Residential properties, such as single-family homes and multi-family units
• Commercial properties like office buildings and retail spaces
• Raw land
• Real estate-related assets such as Real Estate Investment Trusts (REITs) and mortgage notes

The property must be held purely for investment purposes, meaning it cannot be used for personal benefit.

The concept of “prohibited transactions” is central to SDIRA compliance, designed to prevent the IRA owner from personally benefiting from the retirement account’s assets before retirement. A transaction is prohibited if it involves the IRA and a “disqualified person.” Disqualified persons include:

• The IRA holder
• Their spouse
• Ancestors (parents, grandparents)
• Lineal descendants (children, grandchildren, and their spouses)
• Entities in which the IRA holder or other disqualified persons have a significant ownership or control interest

Examples of prohibited transactions specific to real estate are numerous. Purchasing a property from or selling a property to a disqualified person is forbidden. Using the property for personal use by a disqualified person, such as living in it, vacationing there, or operating a business from it, constitutes a prohibited transaction. Additionally, providing services to the property, like performing repairs or renovations, by a disqualified person, or having a disqualified person manage the property for compensation, is not allowed. Any personal guarantee of a loan taken out by the IRA to acquire property is also prohibited, as it represents a personal benefit to the retirement account.

Engaging in a prohibited transaction carries consequences for the IRA. If a prohibited transaction occurs, the IRA is considered to have lost its tax-advantaged status as of the first day of the year in which the transaction took place. This means the entire fair market value of the IRA’s assets is treated as a taxable distribution to the account holder in that year. If the account holder is under age 59½, an additional 10% early distribution penalty may also apply. These consequences underscore the importance of adherence to IRS rules to protect retirement savings.

Tax Considerations and Reporting Requirements

Holding real estate within a Self-Directed IRA introduces tax considerations and reporting requirements. Unrelated Business Taxable Income (UBTI) can apply to income generated by an SDIRA from an active trade or business. While passive rental income from real estate is generally exempt from UBTI, income from certain activities, such as operating a business within the property or engaging in short-term rentals, might trigger this tax. If an SDIRA earns $1,000 or more in gross income from unrelated business activities in a year, it may be subject to UBTI.

A tax implication arises if the SDIRA uses leverage, such as a non-recourse loan, to acquire real estate. This can lead to Unrelated Debt-Financed Income (UDFI), a subset of UBTI. When a non-recourse loan is used, a portion of the income generated by the property becomes taxable as UDFI, proportionate to the debt-financed percentage of the asset. For instance, if 40% of a property’s purchase price was financed with a non-recourse loan, then 40% of the net income generated by that property would be subject to UDFI.

If UBTI or UDFI thresholds are met, the SDIRA itself, through its custodian, may be required to file IRS Form 990-T, Exempt Organization Business Income Tax Return, and pay taxes at trust tax rates. These rates are substantial, with the highest trust tax rate reaching 37% for income over certain thresholds, which can diminish the tax-deferred or tax-free benefits of the IRA. Understanding and planning for potential UBTI/UDFI is important to avoid unexpected tax liabilities.

Distributions from an SDIRA holding real estate align with those for traditional IRAs, but with added complexities due to the illiquid nature of property. Distributions are taxed based on the type of IRA (Traditional versus Roth) and the investor’s age and status. For Traditional IRAs, distributions are taxed as ordinary income, while qualified distributions from Roth IRAs are tax-free.

Required Minimum Distributions (RMDs) apply to Traditional SDIRAs once the account holder reaches age 73, requiring annual withdrawals. Meeting RMDs with an illiquid asset like real estate is challenging, as the property cannot be easily divided. Options to satisfy RMDs include maintaining sufficient cash reserves within the SDIRA, selling a portion of the property, or taking an “in-kind” distribution, where a percentage of the property’s ownership is transferred to the individual, which requires re-titling and can be time-consuming.

Reporting requirements are handled by the SDIRA custodian. The custodian files IRS Form 5498 to report contributions made to the IRA and the fair market value of the account each year. For distributions, IRS Form 1099-R is issued. If the SDIRA incurs UBTI or UDFI, the custodian or the IRA LLC (if applicable) will be responsible for filing IRS Form 990-T. Accurate valuation of real estate assets within the SDIRA is important for proper reporting and RMD calculations.