A self directed IRA is a tax deferred individual retirement accounts that people use to invest their retirement funds in alternative assets like real estate. They offer the same tax benefits as other IRAs – like tax deferment – but have more flexibility when choosing your investments. Only select institutions offer these self directed IRAs.
In this article, we discuss how self directed IRAs work, how you can use them to invest in real estate, as well as how to set up a self directed IRA. By the end, you should understand the benefits of using a self directed IRA to invest in real estate, including a list of providers that can help you get started.
What Self Directed IRAs Are & How They Work
A self directed IRA is a retirement account, and like any other IRA, some basic rules apply. There are tax deductible contributions, penalties for early withdrawals, and tax benefits on money withdrawn after retirement. For example, if you have a traditional self directed IRA, there are tax deferred benefits, and if you have a self directed Roth IRA there are tax free benefits.
However, self directed IRAs let you invest your retirement savings in alternative investments like real estate and is typically used to invest in long term rental properties. In this case, the rental property is “owned” by an LLC in your self directed IRAs name, and all expenses and income flow in and out of the IRA. When you reach retirement age (59.5), you can withdraw the profits and/or sell the property and avoid early withdrawal penalties, taking advantage of either tax deferment or tax free gains.
Annual contribution limits for a self directed IRA include:
- $5,500 if you’re under 50 years old
- $6,500 if you’re 50+ years old
- No limit on the size of a rollover
For this reason, most people fund self directed IRAs with rollovers from other retirement accounts. To do this, you open a qualifying IRA account and LLC with a brokerage and fund it from an existing retirement account. A custodian – which is a company you hire to manage your self directed IRA account – then invests on your behalf in your IRA LLC’s name at your direction, taking responsibility for all real estate transactions. This is why it’s called “self directed.”
Like other retirement accounts, any early withdrawals before retirement age are assessed a 10% early withdrawal penalty. Although, you don’t have to pay capital gains taxes on the sale of real estate held in your self directed IRA after retirement age. This means you can save an additional 15-20% on capital gains taxes when you eventually sell your property.
However, a 10% early distribution penalty tax is applied if you sell a property before retirement age, making a self directed IRA not a good strategy for short term investments. Another thing to watch out for are required minimum distributions that must be taken during retirement, generally by April 1st of the year you turn 70. Seeing as real estate is an illiquid investment, this can cause problems with a self directed IRA and is a downside for some long-term investors.
Self Directed IRA Regulations
There aren’t any restrictions on the type of real estate you can invest in. You can buy a single family home, a condo, a multifamily property, a vacant lot or even an apartment building. However, there are restrictions on the age that you can withdraw funds without a penalty, your contribution limits, and your rollover limits.
You must be 59.5+ to withdraw funds from your self directed IRA to avoid early withdrawal penalties of 10%. If you’re under 50 years old, you can contribute up to $5,500 to your self directed IRA annually, and if you’re 50+ years old, you can contribute up to $6,500 annually. You can also fund the self directed IRA by rolling over funds from another retirement account but consult your financial advisor or CPA first for IRS guidelines and rollover limitations.
Other restrictions on investing in real estate with your self directed IRA include no self-dealing, which means that you or your spouse or immediate family members or any companies that you own 50%+ of can’t can’t be involved with the property. The account holder can’t live in the property or rent the property to himself or self manage the property.
How to Invest in Real Estate Using Your Self Directed IRA
First you need to open a self directed IRA account, and then you open an LLC in the self directed IRAs name. The LLC is the structure that holds the real estate, and the IRA owns the LLC. The LLC is only necessary because you’re investing in real estate with your self directed IRA.
All property transactions, including ownership, is done in the self directed IRA LLC’s name and conducted by your custodian. All rental profits made and property expenses paid flow in and out of the IRA account in the IRA’s name. Upon retirement, you’ll be able to withdraw the profits from the IRA or sell the property and take advantage of tax benefits, such as tax deferment with a traditional self directed IRA and tax free gains with a self directed Roth IRA.
You can invest in real estate using your self directed IRA in 3 steps:
1. Purchase Real Estate With Your Self Directed IRA
Once you identify a property to purchase, you let your custodian know and will instruct them as to what offer to make. This is why it’s called “self directed,” because you don’t make the investments yourself but rather direct the custodian to do it for you.
For example, if you find a real estate deal and want to make an offer of $100,000 on the property, the custodian will present the offer to the seller or the seller’s agent and sign the contracts in the IRA’s name. This means that the property is in your LLC’s name and held by the IRA, so it will receive all of the IRA tax benefits. This LLC can be formed by the custodian or an attorney during the setup process and the cost is generally around $1,000.
All negotiations are done through the custodian. The purchase process and overall timeline is similar to a traditional real estate transaction, with the exception that all funds must be from the IRA account; there is no commingling with personal funds. This means will either need enough money in your self directed IRA account to purchase the property all cash or enough to make a down payment on the property and then apply for a nonrecourse loan. However, it’s possible co-own real estate in your self directed IRA as a tenancy in common.
Take a look at the section below for information on how to set up a self directed IRA.
2. Manage the Property With Your Custodian
Once you have purchased the property, you will need to find tenants to rent it, assuming it’s not already leased. Since there aren’t restrictions on the type of property you can buy, you can either purchase a turnkey property with existing tenants or one that is vacant. If it’s vacant, you’ll either have to find tenants or hire a company to do it for you.
Once the property has tenants, the custodian will hire a property management company and pay them directly from your self directed IRA account. The custodian will collect rent payments in your IRA LLC’s name and also be responsible for paying any costs related to the property, like loan payments, property taxes, and maintenance fees directly out of your self directed IRA account. Custodians typically charge an annual fee starting at $300 but dependent on the number of funds in your account.
This is because as the account owner, you must be completely hands off and can’t self manage the property. Again, no commingling of personal funds is allowed. You also can’t live in the property, even temporarily, and neither can any of your family members since it can’t be directly for your benefit.
3. Distribute Profits and Sell the Property
The property is treated as a long term investment and can’t be sold before you’re 59.5 years old without early withdrawal penalties. Once you reach 59.5 years old, you can sell the property and you won’t pay capital gains tax since the property was held in the self directed IRA. This is different than a traditional IRA in which you do have to pay capital gains taxes.
You can also benefit from tax deferred, or tax free with a Roth, rental income distributions, which can start penalty free at the age of 59.5 and are mandatory starting at age 70.5. Once you start taking distributions, you will see the tax advantages since they will be either tax free or taxed at your current tax rate, which is typically lower than the tax rate you had when actually earning the rental income. Early withdrawal penalties usually consist of a 10% penalty but can vary depending on the circumstances.
Self Directed IRA Real Estate Example
For this example, we’re using a traditional self directed IRA, not a Roth. Let’s say you buy a property for $200,000 with money from your self directed IRA account, which is treated like an all cash purchase. The property is a rental property and the tenant pays $1,500 per month in rent. Taxes, maintenance, and insurance come to $350 per month, custodian fees are $50, and property management fees are $150. This means that your total monthly expenses are $600.
The monthly rent will be deposited into your IRA account each month in your LLC’s name, and your custodian will use this same account to pay all the monthly bills, including their service fee. This means that your monthly rental income is $1500 – $600, which leaves you with $900 per month, or $10,800 per year of retirement income. Currently, your tax rate is 30%.
If the account is short on money, you can roll over money from another retirement account or make deposits, which are limited by the IRS. No personal money can directly pay any bills related to this property and you can’t personally receive any financial gains from this property outside of your self directed IRA account.
Let’s say you reach retirement age in 10 years, so you have made roughly $108,000 ($10,800 x 10) over that time period in tax deferred rental income sitting in your self directed IRA. If you make a withdrawal upon retirement, your tax rate can be as much as 15% lower than the 30% rate you had when you were at your prime working age.
This means you save 15% in taxes – or $16,200 total – on your $108,000 of rental profits when compared to paying taxes when the rental income was actually earned. Let’s now also assume the property appreciated by 20% over the past 10 years, so instead of being worth $200,000, it’s now worth $240,000. If you sell it, you’ll make $40,000 in capital gains, which is free from capital gains tax, meaning you save 15%-20% in taxes on gains, which equals an additional savings of at least $6,000.
To sum it all up, in this example you’d receive a total of $22,200 in tax savings when you purchase and operate a rental property in your self directed IRA account compared to owning it outright.
How to Set Up a Self Directed IRA in 4 Steps
Now that you know what a self directed IRA is and how it works, it’s time to learn how to set one up. It’s advisable to consult with your attorney and accountant before setting up any retirement account. You will also need to decide which company is going to hold your money as a trustee or custodian.
The 4 steps to set up a self directed IRA are:
1. Set up Bank Account & LLC
It doesn’t matter what order you do them, but you need to set up a separate checking account and an LLC for your self directed IRA. This is where an experienced attorney can help you by preparing and filing your Articles of Organization with the state and drafting an LLC Operating Agreement that is IRA custodian-approved.
This is the same LLC that will be used to purchase real estate. The Operating Agreement is just a template that the IRS requires you and the custodian to sign. Although you can set up an LLC yourself, it isn’t recommended since the operating agreement needs to be specific for a custodian. You will also need an IRA custodian-approved subscription agreement and an EIN number for your business.
This 1st step takes about 21 days to complete. Fees vary based on the state requirements and the attorney but are usually in the $2,000 range.
2. Choose a Self Directed IRA Custodian
Your self directed IRA account is administered by a custodian. This custodian is a company that meets the Federal law and IRS guidelines for managing your retirement account. Since you’re not allowed to directly manage the account yourself, the custodian manages it for you. They take care of all transactions related to your self directed IRA.
IRS Publication 590 says that an IRA must be established with a custodian and the custodian must be a bank, a federally insured credit union, a savings and loan association, or another entity that is approved by the IRS. A self directed IRA custodian performs the following:
- They execute transactions on your behalf
- They report to the IRS about how you are using the account
- They keep accounting and financial records on the account
- They handle real estate related tasks such as getting insurance and paying property taxes
This custodian is passive, which means they aren’t selling you stocks or shares and aren’t earning commissions. They are instead investing based on your requests and are paid with fees directly from your IRA account. They get paid annual fees as well as fees to manage the company that manages your property.
A custodian is not an investment advisor so they don’t give investment advice. They also don’t find investment opportunities for you since that goes against the self directed policy. Instead, you direct the custodian as to what and how much you want to invest and they complete the paperwork to make it happen.
Custodians are paid with fees directly from your IRA account. For example, they typically charge annual fees that average $300, as well as fees to manage the company that is managing the property itself.
3. Fund Your Self Directed IRA
You can deposit funds into the account based on the IRS guidelines. If you’re under 50 years old, then you can deposit up to $5,500 annually and if you’re 50+ years old you can deposit up to $6,500 annually. The alternative is rolling over funds from another IRA or Roth IRA account, which is typically advisable seeing as you’ll need much more than $5,500 per year to purchase a property.
Rolling over funds can be more complicated, so it’s important to consult a tax or investment professional on IRS taxation guidelines. This process can take a few days to a week to complete. Fees generally are minimal to initially fund the account and may be around $100.
Keep in mind that the IRA is like its own business so all real estate income must be deposited in this account. All real estate related expenses including maintenance, insurance, and taxes come out of the account as well. You also can’t commingle personal and IRA funds.
Once your self directed IRA is funded, you get to decide how to invest those funds. However, while you can direct your own investments, all self directed IRAs are administered by a custodian and you give your custodian directions regarding how to invest your retirement funds.
Borrowing Money to Fund your Self Directed IRA
If you want or need to finance the property, the mortgage will be a “nonrecourse loan” in the IRA LLC’s name, since “recourse” or traditional loans are considered prohibited transactions by the IRS. A nonrecourse loan means that you aren’t personally liable for the loan and instead the loan is fully secured by the property as collateral. There is no personal guarantee.
These loans are rare in residential real estate since the lender has little recourse if the borrower defaults. They are harder to find than traditional loans, but there are lenders that offer nonrecourse loans.
4. Direct Your Custodian to Invest in Real Estate
After your account is set up and funded, you tell your custodian what you want to invest in. You will choose a neighborhood and then narrow that down to a property and you will direct your custodian to write up an offer for the amount you want to spend on the property.
The custodian will present the offer to the real estate agent or to the seller on your behalf. You don’t negotiate or sign the paperwork, it’s all done by the custodian on your behalf. You choose the investment and you instruct the custodian during the negotiations but you aren’t allowed to directly participate. All of the paperwork will be written in the LLC’s name, which is held by the IRA.
Where to Find a Custodian
A requirement set forth by the IRS is that a self directed IRA is managed by a custodian or a trustee and can’t be managed by the account holder. You can find a custodian by searching online, asking friends or family for a referral or asking your current financial advisor for a recommendation.
Here are a few companies that specialize in managing self directed IRAs:
UDirect is a smaller company but has an A+ rating with the Better Business Bureau. They focus on the administration part of investing and let you focus on choosing your investments. Their site has a fee schedule, links to IRS forms, and offers information on protecting your investments from fraud.
They charge an initial setup fee of $50 and an annual fee of $275 paid in the 1st quarter. They are based in Southern California but have nationwide investors and offer investing webinars to their clients.
Equity Trust was founded over 30 years ago and manages over $12 billion in retirement plan assets. Their one time self directed IRA setup fee is $50 and they have a fee scale based on the amount in your account. For example, an account with $400,000 to $499,00 has an annual fee of $1,025, which is paid in the 1st quarter.
They have 400 representatives to help nationwide investors set up retirement accounts. They also offer educational videos and resources to help their clients learn more about investing.
The Entrust Group
The Entrust Group has over 35 years of experience and manages over $2.7 billion in retirement assets. They have locations in California and Tennessee but service accounts nationwide. They also charge a $50 setup fee and they have a couple options for annual fees.
One is based on the number of assets at $250 per asset. The other fee schedule is a sliding scale based on the asset’s value and can range from $199 to $1,995, and is listed on their site in more detail. They also offer educational tools to learn more about investing and they have focus areas on metals and real estate.
Millennium Trust Company
Millennium Trust Company has more than 20 years of experience as a custodian of self directed IRAs. Like many custodians, they charge a one-time establishment fee of $50 and a $100 annual account fee. They also have various annual holding fees based on the type of assets you hold, with fees ranging from $100 – $600 per year. They also have processing fees totaling as much as $350 for every direct real estate transaction.
PENSCO Trust Company
PENSCO Trust is a regulated, self directed IRA custodian with more than $16 billion in assets under custody. They charge a quarterly asset maintenance fee of $12 as well as processing fees for international real estate transactions. They also charge a quarterly account administration fee between $100 – $275, plus a percentage of the total account value.
Self Directed IRA Fees
Self directed IRAs have a higher number of fees than other IRAs because they can invest in real estate and are required to manage the property and pay any real estate-related bills. There are also establishment fees to open the account and annual renewal fees to keep the funds in the account.
Common fees for self directed IRAs are:
- Establishment fees of $100 to set up the account
- Annual fees that average $300 but are based on the amount of funds in the account
- Service fees to pay bills that range from $25 – $30 per transaction
- Service fees of $25 – $30 each time a service provider such as a landscaper is paid
In addition to these fees, remember to factor in property related costs such as financing costs, property taxes, maintenance fees, insurance fees etc.
Self Directed IRA Tax Benefits
One of the main purposes of a self directed IRA is to invest retirement savings in alternative investments while receiving tax benefits. The contributions you make to your self directed IRA account are tax deductible, and all of your real estate investment income is deposited into the account, tax deferred with a traditional self directed IRA and tax free with a self directed Roth IRA.
This means that with a traditional self directed IRA, you don’t pay yearly taxes on your real estate earnings and instead only pay taxes when you retire. The benefit is that you’re typically in a lower tax bracket when you retire and your taxes will, therefore, be lower. What’s more, any capital gains you make inside your self directed IRA are not subject to capital gains tax if/when you eventually decide to sell the property, which can save you 15 – 20% on your gains.
With a self directed Roth IRA, you’ll pay taxes in the year you earn the rental income, but then any gains on that income, such as if you invest it elsewhere using the self directed Roth, will be tax free. This is beneficial if you expect to use your rental profits to eventually purchase other alternative investments or even more traditional investments like stocks and bonds since the gains are tax free.
Who a Self Directed IRA is Right For
A self directed IRA can be a great vehicle for your retirement savings. It’s right for long term investors and investors who want to use their retirement savings to diversify their portfolio with alternative investments such as real estate.
A self directed IRA is right for the following:
- Investors who want to invest in real estate and other alternative investments through a retirement account
- An investor who wants to invest in an industry they’re knowledgeable about
- An individual who wants to invest outside of stocks and bonds
- Someone who wants to own tangible assets
- A long term buy and hold investor
“I bought a rental property with my IRA in 2015. Using your IRA to buy real estate is much different from investing in your IRA with more traditional avenues like stocks or bonds. You can choose to invest in what you know instead of what an investment advisor tells you to invest in. The great part about buying properties with your IRA is the tax deferred treatment of investments in the IRA.” – Mark Ferguson, Founder, Invest Four More
Pros and Cons of Self Directed IRAs
Self directed IRAs give you more control over your retirement portfolio and you can choose what your custodian will invest in. You can also own properties which can provide rental income and tax benefits during retirement. Keep in mind self directed IRAs are heavily regulated and require a lot of paperwork.
Pros of a Self Directed IRA:
- Investment options – real estate self directed IRA’s offer you a wider range of investment options than the typical stocks, bonds, and mutual funds. In this case, your choices span the wide range of real estate investments and their related financial processes.
- Involves tangible assets rather than “paper” – because much of real estate investing involves “bricks and mortar”, you are purchasing tangible assets with your retirement rather than paper investments which can be volatile and risky.
- Protect and diversify your retirement funds – diversifying into real estate in your retirement accounts limits any over-exposure to traditional financial products that make up most retirement accounts. The additional asset class can add security to your overall retirement portfolio.
- Income and gains are tax deferred – you are able to shelter or get tax advantages, not only for the money you contribute into the account but for the income and capital gains derived from the properties.
- Potentially greater returns – Compared to typical investments in securities, real estate has the potential to produce greater returns. And, those returns are tax-advantaged.
Cons of a Self Directed IRA:
- Future benefit only – as contrasted with regular real estate dealings, any income or gains must be deferred with an IRA. You can’t profit from cash flow or tap into capital gains until you retire. Any withdrawals before age 59 ½ are subject to both normal income tax and hefty tax penalties.
- Not well-known and not many financial institutions offer them – setting up a real estate self directed IRA is complicated by there not being many financial institutions willing to set up these plans.
- Issues related to custodians – custodians must be approved by the IRS, financial institutions offering custodial services will charge fees for them.
- Some activity may be subject to an unrelated business income tax (UBIT) – the IRS may categorize certain income from real estate activity in the IRA as business income as opposed to investment income. In those cases, the income can be subject to something called “Unrelated Business Income Tax” which can be taxed at rates as high as 39.6%.
- There is a lot of regulation – if you handle any of the affairs with the IRA in the wrong manner, it could be disqualified as a retirement account and subject to taxes and penalties. Any activity from buying, to financing, managing, or selling property with the IRA must be handled properly to avoid tax pitfalls.
- They are a lot of work – self directed IRAs, on whole, and real-estate ones in particular, are not “park it and wait” processes. There is a lot of ongoing paperwork and administration that must be handled, and handled correctly.
- Some tax breaks are actually lost – you can’t claim depreciation on property in a real estate IRA, and there may not be a way to take advantage of operating losses.
- Difficulties taking minimum distributions at retirement time – if you are not selling IRA-held property after reaching retirement age, it can be difficult to meet Required Minimum Distributions (RMD) and avoid tax problems.
“You can’t benefit from the real estate holding personally, only the account may benefit and you also can’t manage the property as the IRA holder. The property can’t be used as your vacation property since you can’t personally benefit from it.” -Mike Migone, Senior Advisor, Sperry Van Ness
Frequently Asked Questions (FAQ)
Here are some of the more common questions people ask about real estate self directed IRA’s:
Should I Use a Traditional IRA, Roth IRA, or Other?
There are many options to from which to select – traditional IRA’s, Self Elected Plans (SEP IRA’s), Roth IRA’s, and even something known as a Solo 401k. Consult with your accountant or financial advisor as to which one best meets your financial and tax situation.
Is There Anything I Should Watch Out For?
With the growing popularity of self directed IRA’s, a lot of illegitimate companies and schemes have hit the marketplace. It’s advisable that you stick with well-known banks, financial institutions, and brokers for setting up a real estate self directed IRA and not an unknown company.
Can I Transfer an Existing IRA or Roth IRA to a Self Directed One?
Individuals can typically transfer existing traditional IRA, Roth IRA, or SEP IRA retirement funds into a self directed IRA. Consult with your tax advisor on how to do this.
If I Buy a Property with my IRA Can I Live in the Property When I Retire?
When you retire, you can not purchase the property from the IRA to live in, because it will be considered a prohibited transaction. However, you can have the property retitled and granted to you as a distribution. If you take the property as a distribution it will be taxable. But, if it’s done after age 59 ½, it may be at a potentially lower retiree’s level, there will not be any kind of premature distribution tax penalty.
How Do I Receive a Required Minimum Distribution (RMD) from my IRA?
When you are required to take annual Required Minimum Distributions (RMD), if the IRA is tied up in properties and lacks sufficient cash to meet the required distribution, you can distribute a fractional interest in one or more of the properties valued at the amount of the RMD. You will then personally own the portion that was distributed.
The other option is to simply sell a property and use part of the proceeds to make the required distribution.
Why Haven’t I Heard About Real Estate Self Directed IRA’s Before?
When the current variety of retirement contributing was established in the 1970’s (ie. IRA’s, 401Ks), the government and financial industry set their sights on securities (stocks, bonds, mutual funds) as the most sensible choice for individual investors. Self directed IRA’s of all types were bashed as being too complicated for the average person to understand. Today, with more people experienced in real estate, that thinking has changed.
A self directed IRA gives an investor more control over investment opportunities for their retirement. They can choose to invest in real estate and a broader range of alternative investments than a traditional IRA allows for. A custodian is in control of the self directed IRA and the custodian must abide by IRS guidelines in relation to filing paperwork and maintaining records.