Can You Buy Real Estate With Your IRA Account?

It is generally possible to acquire real estate using an Individual Retirement Account (IRA), though this investment avenue involves a specific set of complexities and stringent rules. While many individuals associate IRAs with traditional investments, the Internal Revenue Service (IRS) permits alternative assets like real estate. Understanding regulations and potential pitfalls is important for investors considering this strategy. Careful attention to these rules avoids adverse tax consequences and aligns investments with retirement goals.

Understanding Self-Directed IRAs

Standard IRA accounts, such as Traditional, Roth, SEP, or SIMPLE IRAs, restrict investments to conventional assets like mutual funds, stocks, and bonds. To invest in real estate, an investor must use a Self-Directed IRA (SDIRA). SDIRAs hold alternative assets not offered by conventional IRAs, giving investors broader control.

SDIRAs follow the same IRS rules for contributions and distributions as other IRAs, but differ in asset types. A qualified custodian or trustee is required for an SDIRA. This custodian holds assets, processes transactions, and ensures IRS compliance, acting as a passive third party.

Establishing an SDIRA requires finding a specialized custodian, as many traditional financial institutions do not offer these services. Funds can be transferred or rolled over from existing retirement accounts, such as a 401(k), Traditional IRA, or Roth IRA, into the new SDIRA. This process can take time, so prompt initiation is advisable. The custodian handles administrative aspects, but investment decisions remain with the SDIRA holder.

Permitted and Prohibited Investments

A Self-Directed IRA allows investment in various property types, including residential, commercial, raw land, and real estate limited partnerships. The IRS imposes strict rules on these investments, primarily through “prohibited transactions” and “disqualified persons.” These rules prevent individuals from gaining immediate personal benefit from tax-advantaged retirement funds.

A prohibited transaction is any improper use of IRA assets by the owner or a disqualified person. Examples include borrowing from the IRA, selling personally owned property to the IRA, or using the IRA as loan security. The IRA holder cannot personally use the investment property for residence, vacation, or any indirect personal benefit. Performing personal labor or “sweat equity” on an IRA-owned property is also prohibited, requiring third-party professionals for maintenance and repairs.

“Disqualified persons” are individuals or entities with whom the IRA is generally prohibited from transacting. This group includes the IRA owner, their spouse, and lineal family members (parents, children, grandchildren, and their spouses). Entities where the IRA holder or other disqualified persons hold 50% or greater interest are also disqualified. Transactions with these individuals or entities are strictly forbidden to ensure the investment remains solely for the benefit of the retirement account.

Engaging in a prohibited transaction carries severe consequences. If such a transaction occurs, the entire IRA account is immediately disqualified as of the first day of that tax year. The fair market value of all assets is then treated as a taxable distribution to the IRA owner, potentially triggering significant income taxes and, if under age 59½, an additional 10% early withdrawal penalty. This can result in a substantial tax liability. Debt-financed property can trigger Unrelated Business Taxable Income (UBIT), a tax on a portion of the property’s income, as explored in the tax implications section.

Acquiring Real Estate Within an IRA

Acquiring real estate with a Self-Directed IRA involves specific procedural steps that differ from a conventional property purchase. Once the SDIRA is established and funded, the investor identifies the desired property. The investor then provides investment direction to the SDIRA custodian, typically through specific forms that detail the property, purchase price, and other transaction specifics.

The SDIRA custodian handles the transaction on behalf of the IRA. The property’s title will be held in the IRA’s name, not the individual investor’s. For example, the title might read “ABC Custodian FBO [Your Name] IRA.” The custodian transfers funds for the purchase and ensures all closing documents are executed in the IRA’s name.

All income generated by the property, such as rental payments, must flow directly into the SDIRA account. Similarly, all property expenses, including taxes, insurance, and maintenance, must be paid directly from SDIRA funds by the custodian. The IRA must have sufficient funds for these ongoing expenses, as personal funds cannot be used.

Direct management of the property by the IRA holder is not permitted, as this is a prohibited transaction. The IRA holder cannot perform hands-on work, collect rent personally, or engage in activities providing direct personal benefit. Instead, a third-party property manager must be hired, with fees paid from the IRA. This separation of duties ensures IRS compliance, maintaining the retirement account’s tax-advantaged status.

Tax Implications of Real Estate in an IRA

Real estate in a Self-Directed IRA benefits from the IRA’s tax advantages. For a Traditional SDIRA, property income, like rental income, grows tax-deferred, with taxes paid upon retirement distributions. A Roth SDIRA allows for tax-free growth and distributions in retirement, provided conditions are met. Property expenses, including operating costs and taxes, are paid from IRA funds within this tax-advantaged framework.

Unrelated Business Taxable Income (UBIT) is a notable tax consideration for real estate within an SDIRA. UBIT applies when an IRA engages in an active trade or business, or, more commonly for real estate, when debt financing is used to acquire property. If a non-recourse loan purchases real estate, the income portion attributable to that debt can be subject to UBIT, even if the property generates passive rental income. This tax applies because debt financing creates an “unrelated debt-financed income” (UDFI) component.

UBIT is calculated on the net income from the unrelated business activity or the debt-financed income portion. If annual gross UBIT income exceeds a threshold, typically $1,000, the IRA must file IRS Form 990-T, “Exempt Organization Business Income Tax Return,” and pay the tax directly from IRA funds. UBIT rates for IRAs are assessed at trust tax rates, which can be significant even at lower income levels. Understanding and planning for UBIT is important to avoid tax liabilities and ensure the real estate investment remains beneficial within the IRA.

For distributions, the real estate investment’s tax treatment follows the underlying IRA type’s rules. For Traditional SDIRAs, all qualified distributions in retirement are taxed as ordinary income. For Roth SDIRAs, qualified distributions are entirely tax-free, including appreciation and income from the real estate. Required Minimum Distributions (RMDs) from Traditional SDIRAs apply at certain ages. For real estate assets, these distributions are based on the property’s fair market value, which may necessitate annual appraisals.