How to Invest in Tax-Free Rental Properties Using a Self-Directed IRA
Many people know about the basic ways to invest in real estate. However, did you know that you can buy real estate using an IRA? Although this path is not particularly common, investors can use a self-directed IRA to purchase rental properties.
Instead of reaping the immediate benefits of the rental income, the IRA collects the income and saves it for a tax-advantaged withdrawal later. People who are looking for reliable passive income to carry them into retirement can benefit from this unique strategy. Here are a few things investors should understand about self-directed IRAs and how they work for investment properties.
Open a Self-Directed IRA
Many people are familiar with an independent retirement account. This type of retirement investment plan allows people to contribute a certain amount of money each year. A self-directed IRA provides a similar process, with a notable difference. Instead of contributing to an IRA that invests in funds independent of the person’s goals, the self-directed IRA funds go to investments of the investor’s choosing.
As with other types of IRAs, investors may be able to choose a Roth IRA or a traditional IRA. A traditional IRA offers tax-deferred contributions, while a Roth IRA accepts after-tax contributions in exchange for tax-free withdrawals after retirement. Investors can direct the funds into real estate investment trusts or even use the funds to buy a rental property.
In addition to other investment services, IRA real estate buyers need to find a custodian to manage the account. The custodian governs the IRA and makes decisions based on the investor’s input in exchange for a fee. Investors may want to consider multiple custodians to determine which services and fee structures work best. In most cases, investors will need to set up a limited liability company to make decisions concerning the IRA. The IRA acts as the property owner, even if the LLC only consists of one investor who makes all the decisions.
Understand the IRS Rules for Investment Real Estate
Given that a rental property owned by a self-directed IRA is a tax-advantaged investment, the IRS sets rules for the types of properties, sellers, and occupancy requirements that are allowed. The guidelines associated with this strategy are similar to the rules for 1031 exchanges.
IRA-purchased properties can only be investments and are never permitted for personal use. Specifically, investors cannot use it as a vacation home, second home, family property, or business location. Some property investments make exceptions for certain circumstances, but not in the case of a self-directed IRA.
The IRS maintains a list of people who cannot take specific actions relating to the assets in the IRA. These people may include:
- Custodians managing the IRA
- Spouses, parents, and grandparents
- Children, grandchildren, and great-grandchildren
The goal of this list is to prevent investors from using the IRA to purchase property from a close relative or another party who has an interest in the property. For example, an investor who wants to convert a primary residence to an investment property cannot use the IRA to buy the home.
Prepare to Buy in Cash
Generally, investors who buy rental properties using a self-directed IRA will pay for most or all of the purchase in cash. It is possible to get a mortgage through this process, but it is less common than mortgages for other real estate investments. Specifically, for the IRA to be able to purchase the property, any mortgage must be a non-recourse loan.
This means that the lender can only take ownership of the collateral in the event of default, and they cannot hold the investor personally liable. Lenders view these types of mortgages as higher risk, and many do not offer them.
Assuming that the IRA has sufficient funds to purchase cash, many investors prefer to take that route. Investors have a few ways to achieve this, such as:
- Contributing the maximum to the IRA for several years to increase the available funds
- Rolling existing retirement funds into the self-directed IRA
- Choosing modest properties like condos or townhomes to sell the rental at a profit later on
- Shopping for properties that require fewer renovations before renting
Investors should keep in mind that there are strict limits on the amount of money they can contribute to the IRA without penalties. As such, they need to plan for upkeep in such a way that they can cover the costs from the IRA.
Beware of Potential Risks
Because the self-directed IRA controls the rental, all expenses must go through the IRA. This means that investors cannot take withdrawals to claim a portion of the rental income until they are eligible to do so without paying taxes and penalties for an early withdrawal.
It also means that the IRA has to have the funds to operate the rental, which includes paying for all the needs of running the property as an investment. Investors can reduce the risk of running into the red by doing the following:
- Buying properties that can be supported by rental income
- Keeping the property occupied with a tenant
- Researching maintenance and planning it on a schedule
- Building a cushion of funds in the IRA for damage or unexpected expenses
Other than minimizing costs and effort associated with the upkeep of the property, investors should also avoid commingling personal funds with those related to the IRA. Since the IRA owns the property, the IRS expects all income and expenses to go directly through the IRA. Any decision to introduce complications to this process, unintended or not, could trigger an IRS investigation.
Making a Wise Investment Decision
As with any investment, the amount of control the investor has over the fund can affect its risk. Many investors prefer to stick with REITs or other real estate investments because they require less research and work to gain a return. For investors looking for ways to branch out, rental properties owned by a self-directed IRA could effectively grow a retirement fund distinctively. By researching, following the rules, and getting tax help, investors can decide if this path is right for them.