Amanda Han, Author & CPA at the Award Winning Keystone CPA, Inc. – Specializing in tax strategies for real estate investors nationwide.
It’s time to break free from the notion that your IRA funds must be confined to the stock market. If you believe that real estate offers better returns, it might be worth considering the possibility of utilizing your IRA for real estate investments. It is important to clarify that I am not advocating taking money out of your IRA as a taxable distribution and using it to buy real estate. I am talking about leaving the money inside your IRA and using the IRA to invest in real estate. Not only does this method help you avoid current taxes, but it also allows the real estate in the IRA to grow tax-free or tax-deferred.
Let’s go over a real-life example of how this can work. Client Jaime is a successful real estate investor who has built a nice portfolio of single-family rentals. Over the past few years, her properties have generated an average of 15% in returns. She has deployed all her available cash into these properties and is looking for ways to continue to build her rental portfolio.
Jaime has also accumulated about $250,000 in her IRA, although she has not been happy with the returns generated in the IRA in the stock market. She would love to get more control of that money by investing it in real estate, an asset class that she has unique knowledge and experience with. Jaime believes that if the money in her IRA can be moved from the stock market into real estate assets, she would be able to generate much better returns. Jaime is already in a high-income tax bracket, so she must be careful in how she moves the money from stocks to real estate without incurring current taxes and penalties. Jaime would not want to take distributions from the IRA to invest in real estate. Distributions can result in unintended taxes and early distribution penalties.
There is a better way to accomplish what Jaime wants to do. The way to do this is via self-directed investing. Contrary to popular belief, it is not difficult to do. This can be done in a simple three-step process.
Step one is to find the right self-directed custodian. There are many reputable self-directed custodians available, so it’s essential to interview several of them to find the one that aligns best with your needs. Once you have identified a suitable self-directed custodian, the first step is to establish an account with them.
Once the account is open, the next step involves rolling over your IRA funds from your current custodian into the new self-directed account. You can complete the necessary paperwork with each custodian to transfer your IRA funds from their current custodian to the new self-directed account.
The third and final step is where the fun begins. Once the funds are successfully transferred, you can begin shopping for assets. There are so many different types of real estate that you can invest in. Here is a short list:
- Long-term rentals
- Overnight vacation rentals
- Midterm rentals
- Self-storage facilities
- Land investments
- Mobile home parks
- Private lending
By following these steps, Jaime would be able to move her $250,000 IRA money from the stock market into real estate assets without incurring any current taxes or penalties. In addition, the cash flow from the rental would go back to the IRA and continue to grow tax-deferred. Now Jaime can put her IRA money to better use and invest in something that she has more control and knowledge about.
The examples in the list above are just a few among endless possibilities. A true self-directed account allows you the freedom to invest your retirement funds in many different asset classes.
It is important to understand, though, that with freedom of choice comes great responsibilities. Things to stay away from when using a self-directed IRA are disqualified assets and prohibited transactions.
Some common examples of disqualified assets that an IRA cannot invest in include collectibles, life insurance contracts and certain types of derivatives. The IRS also prohibits certain transactions from taking place when using retirement funds. It is extremely important to understand these prohibited transactions so that you can work within the rules and regulations to maintain the tax benefits of your retirement account. Getting involved in a prohibited transaction can be extremely costly and can result in some big tax and penalty bills.
Prohibited transaction rules are designed to ensure that your retirement money is not doing business with you, certain people related to you or your businesses. These missteps can be avoided when you do proper planning with your tax advisor.
If you are interested in using self-directed investing, you may be happy to know that it is not just limited to IRAs. In fact, all types of retirement accounts could potentially be self-directed. These include:
- Traditional IRA
- Roth IRA
- Simple IRA
- Spousal IRA
- Inherited IRA
- Solo 401(k)
- Defined benefit plan
By opting for self-directed investing, you can harness the power of your retirement account and invest in what you know best. As with all investments, be sure to exercise due diligence and seek professional guidance to ensure a seamless transition when using your IRA for real estate assets.
The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.
Forbes Finance Council is an invitation-only organization for executives in successful accounting, financial planning and wealth management firms. Do I qualify?