Real Estate can be an important and often successful part of a wealth-building strategy. For this reason, many people buy investment property. However, a major barrier to entering the Real Estate market for many people is a lack of money available for a down payment. Even those who have done a great job saving for their retirement often have most of their savings tied up in accounts that are penalized if the money is withdrawn before age 59 1/2. What most people don’t realize is that the money in a retirement account such as an IRA or an old 401(k) can be used to buy Real Estate or other non-traditional investments. With a self-directed IRA, these funds can be used to make such an investment.
What is a self-directed IRA?
All retirement accounts are maintained in the name of a custodian. A custodian exists, in part, to assure the IRS that you have not tapped into your accounts during the year (thus triggering taxes and potential penalties). In addition, these custodians often assume a level of fiduciary responsibility. As a fiduciary they limit the investments that you can choose from so that they are not held liable for allowing you to invest in something "crazy." Such custodians will not allow use of a retirement account to invest in Real Estate.
However, a few custodians offer what is called a self-directed IRA. In this case the custodian withdraws its fiduciary responsibility and allows you to choose the investments that you think are appropriate. With this option, you can take the money that is in your IRA, or that is in a 401(k) from a previous employer, and use those funds to purchase investment property, precious metals, or even a new business. The ability to use these funds in such a way allows for significant risks to your investment, but also offers two great benefits that would not otherwise be available.
Two Great Benefits of a Self-directed IRA
The first benefit is probably obvious from what has been said so far. You are able to invest the money in your retirement savings account in almost any way that you feel is best. You can choose the investment that you think will bring the greatest success in preparing for your future needs and you have a source of money for such investments that you may not have realized was available to you.
The second benefit may be quite as obvious. This benefit comes at tax time. Since the property is held within an IRA, all income and gains are tax deferred. No longer do you have to pay taxes each year on the rental income, but can defer that income to a future time. You can keep the income within the IRA account and reinvest it elsewhere, or have it in reserve for future expenses. Even more exciting is that if you decide to sell the property and buy another, or even if you just keep the gains and invest in something else, it isn’t necessary to deal with the headaches of a 1031 exchange. Timing of sales and purchases can thus be made when they are optimal instead of being forced to buy something within the strict 1031 guidelines in order to avoid the taxes.
Some Words of Caution
Of course, you must use great prudence and caution when investing your retirement savings. You should not, for example, "put all of you eggs in one basket" by using all of your money to buy one property. You must also be aware of the many risks that are inherent in Real Estate, including a measure of illiquidity.
Additionally, you must remember that the IRA owns the property. Should you need to make repairs or replace the roof that money needs to come from the IRA. Otherwise, if you pay for anything out of pocket, it is considered a contribution to your IRA (subject to all of the limitations of an IRA). Therefore it would be wise to have a significant portion of your IRA money in reserve (not invested in the property) so that you are free to make adjustments as needed.
You also need to be aware of some special rules. For example, you must use an independent property manager to receive the income and pay the expenses. Remember, the IRS doesn’t want you to touch the money in your IRA, and in this situation any money involved in the investment would count. The property manager would collect income and send it to the IRA custodian would bill the custodian for expenses. The custodian will also charge a fee for this service. You still have control over the property manager; you just can’t touch the money. The rules for owning a business within an IRA become even more complicated. With any such investment you must be sure that you first completely understand how it works.
The tax benefits of this type of investment can be enormous. The ability to tap into retirement funds to make a great investment can be wonderful. But the decision to make such investments through a self-directed IRA should be made with the help of competent professionals, in order to avoid serious pitfalls. With that said, a self-directed IRA is a lesser-known option that can be a great asset in your strategy for financial independence and tax-benefited investments.
* This article is commentary on basic principles. In no way should the things said in the article be construed or interpreted to be advice for your specific situation. Before making any financial decision you should consider all factors and consult with a professional.