How to Use Your IRA to Buy Real Estate

Investing in real estate offers a path to diversifying retirement savings, and Individual Retirement Accounts (IRAs) can serve as a vehicle for such investments. While traditional IRAs typically limit investment options to publicly traded securities, a specialized structure allows for the inclusion of tangible assets like real estate. This approach requires strict adherence to IRS regulations to maintain the tax-advantaged status of retirement funds.

Understanding Self-Directed IRAs for Real Estate

A Self-Directed IRA (SDIRA) stands apart from a traditional IRA by offering an expansive range of investment choices beyond common stocks, bonds, and mutual funds. Standard IRA custodians do not facilitate investments in alternative assets like physical real estate, making an SDIRA necessary for property holdings. The SDIRA operates under the same IRS rules regarding contributions and distributions as conventional IRAs, but it allows the account holder to direct investments into a broader spectrum of assets.

The core function of an SDIRA relies on a specialized custodian or trustee, a financial institution approved by the IRS to hold alternative assets. This custodian is responsible for administering the account, ensuring compliance with IRS regulations, and processing transactions as directed by the IRA holder. They act as the fiduciary, holding the assets for the benefit of the IRA owner. The custodian executes the investment decisions made by the account holder.

Some SDIRA structures can provide “checkbook control,” which involves the SDIRA investing in a wholly-owned Limited Liability Company (LLC). The IRA owner then acts as the manager of this LLC, enabling them to make investment decisions and disburse funds directly from the LLC’s bank account without requiring the custodian’s direct approval for every transaction. This setup offers greater efficiency and quicker access to funds for real estate deals, attractive for active investors.

While checkbook control offers convenience, it also places a greater burden of compliance and record-keeping directly on the IRA owner. The LLC structure must be meticulously maintained to ensure the IRA’s tax-advantaged status is preserved. All funds must flow through the LLC, and the IRA owner must ensure all actions taken as the LLC manager adhere to the strict prohibited transaction rules set forth by the IRS. The custodian’s primary role remains overseeing the IRA’s investment in the LLC.

Permitted and Prohibited Real Estate Investments

A Self-Directed IRA can invest in a wide array of real estate assets, providing flexibility for diversification. These include residential and commercial properties, raw land, and even certain real estate investment trusts (REITs) or mortgage notes. The IRS permits any investment not specifically prohibited, provided it adheres to rules against self-dealing and transactions with disqualified persons.

A fundamental aspect of SDIRA real estate investing involves understanding “prohibited transactions.” These are forbidden actions that allow the IRA owner or related parties to personally benefit from IRA assets outside of the account’s tax-deferred or tax-free growth. For instance, an IRA cannot purchase property from, sell property to, or provide a loan to the IRA owner or any “disqualified person.”

“Disqualified persons” include the IRA owner, their spouse, ancestors (parents, grandparents), lineal descendants (children, grandchildren), and their spouses. Entities owned 50% or more by disqualified persons are also included in this definition. Any transaction between the SDIRA and a disqualified person is strictly prohibited, regardless of how fair the terms might seem.

Specific examples of prohibited transactions in real estate include using an IRA-owned property for personal use, such as a vacation home, even for a single night. The IRA owner or any disqualified person cannot live in, rent, or lease property owned by the SDIRA. Furthermore, the IRA owner cannot perform any personal services or “sweat equity” to improve or maintain the property, such as making repairs or renovations.

Such actions are considered self-dealing, as they would provide a direct personal benefit to the IRA owner, which is against IRS rules. All services must be contracted and paid for by the IRA. The overarching principle is that all investments and related activities within an SDIRA must be solely for the benefit of the retirement account.

The IRA’s assets must grow within the account without providing any current, direct benefit to the IRA holder or disqualified persons. Violating these rules can lead to severe consequences, potentially disqualifying the IRA and treating it as a taxable distribution, incurring immediate taxes and penalties.

Establishing Your Self-Directed IRA

The first step in using an IRA for real estate involves establishing a Self-Directed IRA account, distinct from a standard brokerage IRA. This process begins by selecting a specialized SDIRA custodian or trustee. Unlike traditional financial institutions, these custodians are equipped to hold non-traditional assets like real estate. The choice of custodian is important, as they will play a central role in facilitating transactions and ensuring compliance.

When choosing a suitable SDIRA custodian, consider their fee structure, the range of services offered, and their experience with real estate investments. Some custodians charge setup fees, annual administration fees, and transaction-based fees, so understanding the cost implications is helpful. Select a custodian with expertise in real estate transactions, as they can help navigate titling and funding property acquisitions.

Once a custodian is chosen, the next step is to open the SDIRA account by completing their application forms. This typically involves providing personal identification and selecting the type of IRA, such as a Traditional SDIRA or a Roth SDIRA, based on individual tax planning goals. A Traditional SDIRA offers tax-deferred growth, with distributions taxed in retirement, while a Roth SDIRA is funded with after-tax contributions, allowing for tax-free growth and qualified distributions in retirement.

After the account is established, it needs to be funded. There are generally three ways to fund an SDIRA: through rollovers from existing retirement accounts, transfers from other IRAs, or direct annual contributions. A direct rollover from an employer-sponsored plan, such as a 401(k) or 403(b), involves the funds moving directly from the old plan administrator to the new SDIRA custodian, avoiding any personal receipt of funds. This is typically a tax-free and penalty-free process.

An indirect rollover involves the account holder receiving funds from their old retirement account and then depositing them into the new SDIRA within 60 days to avoid taxes and penalties. Transfers from existing IRAs are generally simpler, as funds move directly from one IRA custodian to another without the account holder taking possession, and there is no limit on the number of such transfers. Annual contributions can be made up to the IRS-specified limits, similar to traditional IRAs, allowing for incremental funding of the account.

The Real Estate Acquisition Process

Once a Self-Directed IRA is established and funded, the focus shifts to the practical steps of acquiring real estate. The entire acquisition process must be conducted in the name of the IRA, not the individual. This distinction is paramount to maintaining the IRA’s tax-advantaged status and avoiding prohibited transactions.

The initial phase involves finding a suitable property. This can include residential homes, commercial buildings, or vacant land, provided the investment aligns with the SDIRA’s purpose of generating retirement income. Due diligence for the property should be conducted from the IRA’s perspective, meaning the investment decision must be sound for the retirement account.

This includes assessing market value, potential rental income, and property condition. When making an offer on a property, all contracts and agreements must clearly name the SDIRA as the buyer. For example, the offer should be made in the name of “[Custodian Name] FBO [Your Name] IRA Account # [Your Account Number]” or similar phrasing. This ensures the IRA is the legal entity entering into the purchase agreement.

Any earnest money deposits must also come directly from the SDIRA’s funds. During the closing process, the SDIRA custodian plays a necessary role. The custodian will sign all required documents on behalf of the IRA, as the IRA owner cannot personally sign these documents.

Funds for the purchase, including the down payment and closing costs, are transferred directly from the SDIRA account to the seller or escrow agent by the custodian. Ensure the SDIRA holds sufficient cash to cover the purchase price and all associated expenses. Correct property titling is fundamental.

The property’s title must be vested in the name of the SDIRA custodian for the benefit of the IRA, not in the individual’s personal name. An example of proper titling would be “Custodian Name FBO [Your Name] IRA Account #[Account Number].” This ensures legal ownership remains within the IRA, separating it from personal assets and preserving the IRA’s tax-advantaged status. Failure to title the property correctly can lead to the IRA being disqualified, resulting in the entire account’s value being considered a taxable distribution.

Ongoing Compliance and Tax Considerations

Managing a real estate asset within a Self-Directed IRA requires continuous attention to IRS compliance and specific tax considerations after the acquisition is complete. All income generated by the property, such as rental payments, must flow directly back into the SDIRA account. Similarly, all expenses related to the property, including property taxes, insurance premiums, maintenance costs, and utility bills, must be paid directly from the SDIRA’s funds.

The use of personal funds for any property-related expense is considered a prohibited transaction and can jeopardize the IRA’s tax status. A significant rule involves property management: the IRA owner cannot personally perform work on the property. This includes any form of “sweat equity” such as repairs, renovations, or even routine maintenance like painting or mowing the lawn. Engaging in such activities would be considered self-dealing, a prohibited transaction, as it provides a personal benefit to the IRA owner.

Instead, all services must be performed by unrelated third parties who are paid fair market value from the SDIRA. While the IRA owner can oversee the property management, they must ensure all contractors and service providers are compensated directly from the IRA.

One of the more complex tax considerations for SDIRA real estate involves Unrelated Business Taxable Income (UBTI) and Unrelated Debt-Financed Income (UDFI). UBTI can arise if the IRA engages in an active trade or business, which is generally not the case for passive rental income. However, UDFI is particularly relevant for real estate investments that involve debt financing, such as a non-recourse loan.

If an SDIRA uses a non-recourse loan to purchase real estate, a portion of the income generated by that property (both rental income and capital gains from sale) may be subject to UBTI in the form of UDFI. The percentage of income subject to UBIT is typically proportional to the percentage of the property that is debt-financed. For example, if 50% of the property was financed with a loan, 50% of the net income could be subject to UBTI. This tax is levied on the IRA itself, not the individual, and tax rates for UBTI can be similar to trust tax rates, potentially as high as 37%.

An SDIRA must file IRS Form 990-T if it has gross income from an unrelated trade or business of $1,000 or more. Regarding future distributions, the tax implications depend on the type of SDIRA.

For a Traditional SDIRA, distributions taken after age 59½ are taxed as ordinary income at the IRA owner’s prevailing income tax rate. Required Minimum Distributions (RMDs) typically begin at age 73 for Traditional IRAs, and failure to take these can result in significant penalties. For a Roth SDIRA, qualified distributions after age 59½ and after the account has been open for at least five years are entirely tax-free. Early distributions from either account type, before age 59½, may be subject to a 10% penalty in addition to ordinary income tax, unless a specific IRS exception applies.