Can I Buy A Rental Property With My IRA?

Investing in rental property using an individual retirement account (IRA) is a strategy that savvy investors can use to diversify their portfolios and benefit from real estate's potential for high returns. While traditional IRAs typically limit investments to stocks, bonds and mutual funds, self-directed IRAs (SDIRAs) offer the flexibility to invest in rental properties.

Understanding SDIRAs For Real Estate Investments

SDIRAs allow you to invest in almost any asset, including real estate. It's essential to choose the right custodian for your SDIRA. You can consider options like New Direction Trust Co. or refer to the IRS list of approved nonbank trustees and custodians. When selecting a custodian, research their licensing, registration and reputation with regulatory authorities and the Better Business Bureau (BBB).

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Financing And Purchasing Rental Property With An SDIRA

Typically, buying rental property with an SDIRA involves using cash from your IRA. Financing options such as nonrecourse loans are available. A nonrecourse loan is secured by the property, and the lender's recourse is limited to the property in case of default, protecting the IRA owner's assets.

Similarly, investing in real estate investment trusts (REITs) through an IRA is possible and can provide tax benefits. REITs, which primarily involve ownership and management of income-producing real estate, must distribute at least 90% of their taxable income to shareholders as dividends. 

When investing in a REIT through a traditional IRA, contributions are tax-deductible and earnings grow tax-deferred. Roth IRAs, funded with after-tax contributions, offer tax-free earnings and withdrawals. 

When an IRA earns gross unrelated business taxable income (UBTI) over $1,000 annually, it must file a tax return and pay taxes at corporate rates. This obligation falls on the IRA, not its owner or beneficiary. While purchasing rental property and investing in REITs through an SDIRA offer unique opportunities for real estate investment, they also require careful consideration of financing options and potential tax implications. 

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Managing Rental Property In An SDIRA

All expenses and capital repairs related to the rental property must be paid from the SDIRA. Common operating expenses include advertising, tenant screening, property management fees, repairs, maintenance and taxes. 

The 50% rule suggests that expenses should not exceed half of the rental income collected. Any rental income and profits must remain in the SDIRA, and although profits are tax-free until withdrawals, you miss out on some tax benefits like depreciation expenses or mortgage interest deductions.

Checkbook IRA For Easier Management

For managing everyday expenses and transactions of rental properties, a checkbook IRA could be an efficient option. This involves setting up an IRA limited liability company (LLC) or trust and a checking account in the name of the entity. It allows direct handling of property costs without going through a custodian for each transaction.

Legal Protections And Active Participation

An IRA LLC provides asset protection similar to an LLC used in other business activities, shielding your IRA from creditors. As an SDIRA real estate owner, you gain more control over your investments, deciding on property management, rental rates and when to buy or sell properties.

Understanding the Pros and Cons

Investing in rental property with an SDIRA can increase your retirement funds tax-free. Risks and other considerations to keep in mind include:

Pros:

• Diversification of retirement portfolio
• Hedge against inflation with rental property
• Tax-free profits
• Ability to buy and sell properties without a 1031 tax-deferred exchange

Cons:

• Potential reduction in portfolio diversification
• Restrictions on personal or family use of the property
• All expenses must be paid with SDIRA funds
• Potential unrelated debt-financing income (UDFI) tax if using a mortgage or other financing

Compliance With Self-Directed IRA Real Estate Rules

It's important to understand and comply with the rules set by the IRS for SDIRA real estate investments. This includes adhering to prohibited transactions and knowing who qualifies as disqualified persons. Violating these rules can lead to the disqualification of your IRA and unexpected tax liabilities.

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*This information is not financial advice, and personalized guidance from a financial adviser is recommended for making well-informed decisions.

Jeannine Mancini has written about personal finance and investment for the past 13 years in a variety of publications including Zacks, The Nest and eHow. She is not a licensed financial adviser, and the content herein is for information purposes only and is not, and does not constitute or intend to constitute, investment advice or any investment service. While Mancini believes that the information contained herein is reliable and derived from reliable sources, there is no representation, warranty or undertaking, stated or implied, as to the accuracy or completeness of the information.