In the midst of the U.S. housing market’s rebound and ongoing stock market volatility, real estate has become an increasingly attractive asset class for individuals looking to invest for retirement. Investing in real estate can provide portfolios with much-needed diversification as well as the potential for capital gains. However, many investors are not aware they have access to another source of capital that can be used to buy real estate: a retirement account.
Personal retirement funds, like those held in IRAs, are an often-overlooked source of capital because most investors (and real estate professionals) do not know it’s possible to invest IRA funds beyond stocks, bonds and mutual funds. But by choosing a self-directed IRA, account owners can gain access to alternative investments such as real estate—from condominiums and office complexes to REITs or tax liens. Additionally, using an IRA to invest in real estate provides investors with the added benefit of investing with tax-advantaged dollars.
What We Mean by ‘Tax-Advantaged’
When a real estate investor uses retirement dollars, taxes on income from return on investment are deferred until it’s time to take distributions. If the investor uses a Roth IRA, in many cases account holders can avoid paying taxes entirely on distributions or profit generated by the sale of the property. (In all cases, reviewing the investment with a tax professional is a good idea.)
Before you run out and try this strategy, though, it is important to understand how buying and maintaining real estate in an IRA differs from traditional property investments. For instance, regardless of the asset type, the investment must be purchased with funds held in the IRA, and the title needs to be in the name of the IRA custodian for the account. (You can read more about self-directed IRA custodians here.)
There are also certain regulations of which to be aware when it comes to investing in real estate with a self-directed IRA. One example is that self-directed IRAs are prohibited from holding any assets that are used for the owner’s personal benefit—i.e., you cannot buy your primary residence with IRA funds.
Common Ways of Investing in Real Estate
Once investors are aware they can make a real estate investment with their IRAs, their next question is usually, “How?” Here are some of the most common ways investors choose to invest in real estate:
- Direct purchase:
The IRA buys the entire property outright using funds in the account. The income and expenses flow directly in and out of the IRA.
- Partnerships or tenants-in-common purchase:
These transactions combine the investor’s IRA funds with other investors’ funds or with the IRA owner’s non-IRA funds. The investment income and expenses are handled proportionate to each entity’s ownership amount.
- Mortgage-backed purchase:
In these purchases, the IRA borrows money to purchase property. An important caveat to note is that neither the IRA, nor the account owner, can have any personal liability in the mortgage (investors cannot back their own loans). Also, a non-recourse loan must be used so that the lender can only seize the actual property being purchased and not the rest of the IRA’s assets if the borrower defaults on the loan. All mortgage payments are made with IRA funds. In addition, if property purchased in an IRA is financed by debt, income produced by that property, as well as gain on sale, could be subject to tax. It’s always best to consult with a tax professional in these situations.
- Limited Liability Corporation:
In these transactions, the property title is held in the name of the LLC. In this case, the IRA holds an interest in the LLC rather than title to the property.
Interested in learning more about how to leverage this tax-advantaged strategy? Check out our free Real Estate Investors Guide! In it you’ll learn more about applicable regulations, prohibited transactions and ways to structure your investment.
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