How to Use a Self-Directed IRA to Invest in Real Estate

Investing for retirement often involves traditional assets. However, some retirement vehicles allow diversification into alternative assets, including real estate. Using an Individual Retirement Arrangement (IRA) for real estate offers tax advantages but requires strict adherence to Internal Revenue Service (IRS) regulations to avoid penalties and maintain its tax-advantaged status.

Understanding Self-Directed IRAs

A Self-Directed IRA (SDIRA) allows investors to hold a broader range of assets than traditional IRAs, including real estate, private equity, and precious metals. This provides greater control and diversification for retirement savings.

The SDIRA custodian, or trustee, facilitates these alternative investments. The IRS requires a qualified custodian to hold legal title to all IRA assets on behalf of the owner. The IRA itself owns the real estate, not the individual, with the custodian administering transactions. This structure ensures compliance and tax-advantaged growth of retirement funds.

SDIRAs are available in various forms, including Traditional SDIRAs (tax-deductible contributions, tax-deferred growth) and Roth SDIRAs (after-tax contributions, tax-free distributions). SEP IRAs and SIMPLE IRAs can also be self-directed, each with specific rules. The chosen SDIRA type depends on an individual’s financial situation and retirement goals.

Permitted Real Estate Investments

An SDIRA can hold various real estate assets, provided they are acquired for investment purposes. Residential rental properties, like single-family homes and multi-family units, are common for rental income. Commercial properties, such as office buildings, retail spaces, and industrial facilities, also qualify.

Raw land, held for appreciation or future development, is another option. An SDIRA can also invest in real estate notes, like mortgages, where the IRA acts as the lender and receives interest. Tax liens and deeds are specialized investments, allowing the IRA to acquire property or secure a return through overdue property taxes.

Private real estate funds or partnerships are permissible if structured to avoid prohibited transactions and disqualified persons. Any real estate purchased by an SDIRA must be used solely for investment and not for the personal use or benefit of the IRA holder or any disqualified persons, including certain family members.

Prohibited Transactions and Disqualified Persons

Adhering to rules regarding prohibited transactions and disqualified persons is important when using an SDIRA for real estate. A prohibited transaction is any improper use of IRA assets by the owner, beneficiary, or a disqualified person. This can lead to severe consequences, including immediate IRA disqualification, making all assets taxable and subject to penalties.

Disqualified persons include the IRA owner, their spouse, ancestors (parents, grandparents), lineal descendants (children, grandchildren), and their spouses. Any entity (such as a corporation, partnership, or LLC) in which the IRA owner or other disqualified persons hold a 50% or greater interest is also disqualified. Fiduciaries and service providers to the IRA are considered disqualified persons.

Specific examples of prohibited transactions involving real estate are numerous. The IRA cannot buy property from, or sell property to, a disqualified person. Using SDIRA-owned property for personal benefit, such as living in it, vacationing there, or allowing a disqualified person to use it, is prohibited.

Performing services for the SDIRA property, such as personal repairs or maintenance, is prohibited. All services and expenses must be conducted by independent third parties paid directly from SDIRA funds. Receiving direct or indirect personal benefits from the property is forbidden. For example, all rental income must go directly into the SDIRA account, and personal funds cannot pay for property expenses. Borrowing money from the SDIRA or using it as security for a personal loan is also prohibited.

Setting Up and Funding Your Self-Directed IRA

Establishing and funding an SDIRA for real estate involves specific steps. The first step is selecting an SDIRA custodian. These specialized custodians handle alternative assets like real estate. When choosing a custodian, look for experience in real estate, transparent fees, and responsive customer service. Custodian fees typically include a one-time setup fee, annual maintenance fees, and transaction-based fees, ranging from under $100 to several hundred dollars annually.

Once a custodian is chosen, open the SDIRA account. This involves completing an application, providing personal identification, and designating beneficiaries. The custodian will require documentation to verify identity and ensure correct setup. Specify the SDIRA type (Traditional or Roth) at this stage, as it impacts future tax treatment.

Funding the SDIRA can be accomplished through several methods. A common approach is a rollover from an existing qualified retirement plan, such as a 401(k) or another IRA. A direct rollover, where funds are moved directly from the old plan administrator to the new SDIRA custodian, is often preferred as it avoids potential tax withholdings and the 60-day deadline associated with indirect rollovers. Alternatively, an individual can transfer funds from an existing IRA to the new SDIRA, which is typically a simpler process as funds move directly between IRA custodians without the account holder taking possession. Annual contributions, up to the IRS-specified limits, are also a way to fund an SDIRA.

Executing Real Estate Investments Through Your SDIRA

Once a Self-Directed IRA (SDIRA) is established and funded, the practical steps for executing a real estate investment begin, always with the understanding that the IRA is the legal owner. The initial phase involves identifying a suitable investment property, which requires the IRA holder to conduct thorough due diligence, including market research and property analysis. The SDIRA custodian, however, cannot provide investment advice, as their role is purely administrative.

When an investment property is identified, all offers and purchase agreements must be made in the name of the SDIRA, not the individual. The property should be clearly designated as belonging to the IRA, typically structured as “[Custodian Name] FBO [Your Name] IRA.” This ensures that legal ownership is vested in the retirement account. The IRA holder then submits the necessary purchase and closing documents to the SDIRA custodian for review and signature, as the custodian acts on behalf of the IRA.

Funding the purchase requires the custodian to disburse funds directly from the SDIRA account. All financial transactions, including earnest money deposits, must flow from and to the SDIRA. For instance, if a property costs $200,000, the custodian will release the funds from the IRA to the seller or closing agent. The property deed must be titled precisely in the name of the SDIRA custodian “for the benefit of” (FBO) the IRA, explicitly stating the custodian’s name, the IRA holder’s name, and the IRA account number.

Ongoing property management and expenses must also strictly adhere to SDIRA rules. All income generated by the property, such as rental payments, must be deposited directly into the SDIRA account. Conversely, all expenses related to the property, including property taxes, insurance, maintenance costs, and utility bills, must be paid directly from the SDIRA funds. The IRA holder must instruct the custodian to pay these expenses, and personal funds cannot be used, nor can the IRA holder perform “sweat equity” on the property. This strict separation of personal and IRA funds is critical for maintaining the tax-advantaged status of the SDIRA.