How to Use Your IRA to Buy Real Estate

Investing in real estate through an Individual Retirement Account (IRA) presents a unique avenue for retirement planning. While many IRAs focus on publicly traded securities, a specific type of IRA allows individuals to include real estate in their retirement portfolios. This approach involves distinct regulations and considerations that differ significantly from direct personal real estate ownership. Understanding these rules is important for anyone considering this investment strategy.

Understanding Self-Directed IRAs

A Self-Directed IRA (SDIRA) allows the account holder to invest in a broader range of assets than conventional brokerage IRAs. Unlike traditional IRAs, an SDIRA puts investment decision-making power directly in the hands of the account owner. This includes the ability to invest in alternative assets such as real estate, precious metals, and private equity.

While the individual directs investments, a qualified custodian or trustee is legally required to hold the assets and administer the account. This custodian is not an investment advisor; their role is to ensure transactions comply with Internal Revenue Service (IRS) regulations, handle record-keeping, and fulfill reporting requirements.

Various types of IRAs, including Traditional, Roth, SEP (Simplified Employee Pension), and SIMPLE (Savings Incentive Match Plan for Employees), can be structured as self-directed accounts. The “self-directed” aspect refers to the wider investment choices available, enabled by a custodian willing and capable of managing alternative assets like real estate.

Permitted Investments and Prohibited Transactions

Self-Directed IRAs can invest in a wide array of real estate assets, provided they are held for investment purposes. This includes residential properties, commercial properties, raw land, rental properties, real estate notes, and tax liens. The property must be acquired solely for investment, meaning it cannot be used for personal benefit by the IRA holder or certain related individuals.

The IRS has rules regarding “prohibited transactions” to prevent self-dealing and ensure the IRA remains a retirement vehicle. A transaction is prohibited if it involves the IRA and a “disqualified person.” Disqualified persons include the IRA holder, their spouse, ascendants, descendants, spouses of descendants, and any entities controlled by these individuals.

The IRA cannot purchase property from, sell property to, or lease property to a disqualified person. The IRA cannot lend money to a disqualified person, nor can IRA assets be used as security for a loan to a disqualified person. Using IRA-owned property for personal benefit, such as living in a rental property or using a vacation home, is strictly forbidden.

Providing services to the IRA or its property that benefit a disqualified person is also prohibited, including performing maintenance, renovations, or property management. All transactions must occur as if between unrelated parties, with no direct or indirect personal benefit to the IRA holder or disqualified persons. Violating these rules can result in the entire IRA being disqualified, making the full account balance immediately taxable, subject to penalties, and losing its tax-deferred or tax-free status.

Acquiring and Managing Real Estate Through Your IRA

Acquiring real estate with an SDIRA begins with selecting a suitable custodian. Choose a custodian experienced with real estate investments, as not all financial institutions offer this specialized service. Factors to consider include their fee structure, client reviews, and the level of administrative support they provide, keeping in mind they cannot offer investment advice.

Once a custodian is chosen, the SDIRA must be funded. This can be achieved through direct contributions, rollovers from employer-sponsored retirement plans like 401(k)s, or transfers from existing IRAs. The funds are then held by the SDIRA custodian, ready for investment.

Identifying and evaluating potential real estate investments is the next step, much like any traditional real estate purchase. All documents must be in the name of the SDIRA, not the individual. The custodian is responsible for signing the necessary paperwork on behalf of the IRA, and the property title will be held by the IRA, not the individual.

Managing the property after acquisition requires careful adherence to IRS rules. All income generated from the property, such as rental payments, must be deposited directly into the SDIRA account. All expenses related to the property, including property taxes, insurance, maintenance, repairs, and utility bills, must be paid directly from the SDIRA funds. The IRA holder cannot use personal funds for these expenses. If property management services are needed, they must be provided by an unrelated third party. When the property is eventually sold, all proceeds must flow back into the SDIRA account, maintaining its tax-advantaged status.

Tax Implications of IRA Real Estate Investments

Real estate held within a Self-Directed IRA benefits from the tax-advantaged nature of the retirement account. Rental income and any appreciation in property value grow either tax-deferred in a Traditional, SEP, or SIMPLE IRA, or entirely tax-free in a Roth IRA. This means no annual taxes on rental income or capital gains while the asset remains within the IRA.

A tax consideration for SDIRA real estate investments is Unrelated Business Taxable Income (UBTI) and its subset, Unrelated Debt-Financed Income (UDFI). UBTI is a tax levied on income a tax-exempt entity, like an IRA, earns from activities not substantially related to its tax-exempt purpose. This tax aims to prevent tax-exempt entities from gaining an unfair competitive advantage over taxable businesses.

UDFI applies when an IRA uses leverage, such as a non-recourse loan, to purchase real estate. If a property is acquired with borrowed funds, the portion of net profit attributable to that debt is subject to UDFI and the Unrelated Business Income Tax (UBIT). For instance, if half of a property’s purchase is debt-financed, then half of the income generated from that property may be subject to UBIT. The UBIT is paid by the IRA itself, not the individual, and the IRA may need to file IRS Form 990-T. An IRA is allowed a $1,000 deduction on UBTI.

Property taxes, insurance, and maintenance expenses are paid from SDIRA funds, but these expenses are not personally deductible by the IRA holder because the IRA, not the individual, owns the property. When funds are distributed from the SDIRA, they are subject to standard IRA distribution rules and taxes applicable to the specific IRA type. Traditional IRA distributions are taxed as ordinary income, while qualified Roth IRA distributions are tax-free.