Should Your Client Buy Real Estate in an IRA?

What You Need to Know

Real estate is one of the most popular investments in self-directed IRAs.
Real estate in an IRA offers diversification and the potential for long-term gains.
A number of rules surround alternative assets such as real estate in an IRA, and it’s important that clients are aware of these rules to avoid costly mistakes.

Self-directed IRAs allow investors to hold a variety of alternative assets inside the accounts. One of the most popular investments for self-directed IRAs and other self-directed retirement accounts is real estate.

Real estate holdings in an IRA can include such investments as:

Vacant land
Residential real estate such as a single-family home or duplex used as a rental property
Apartment buildings and condos
Commercial property such as office buildings, manufacturing facilities, warehouse space and retail holdings
Mortgage notes to finance real estate transactions for others — secured loans made between the client’s IRA and the borrower
Real estate investment trusts (public, private, traded and non-traded)

Here are some considerations for those who may be interested in holding real estate investments inside a self-directed retirement account.

Why Invest in Real Estate?

Real estate offers several advantages for clients when held inside a self-directed IRA.

Real estate offers diversification beyond traditional asset classes like stocks and bonds.
Direct investments in real estate tend to have a long time horizon and can coincide with clients’ time horizon for their IRA.
When investing directly in real estate or mortgages, clients can personalize their investment choices rather than relying on the choices made by a fund manager.

Benefits of Real Estate Inside an IRA

There are a number of potential benefits for clients owning real estate inside an IRA or other self-directed retirement account.

Appreciation of any property or other type of real estate inside the IRA will grow tax-deferred (or tax-free, in the case of a Roth IRA). Depending upon the property and size of the investment, these gains could be substantial, and the ability to defer or to not pay taxes at all can be significant.
Income earned from rental properties, such as rental payments or interest earned from private mortgage notes, will grow tax-deferred or tax-free inside the IRA.
Any gains from the sale of a property can be invested in additional real estate assets or into any other type of investment inside an IRA. The same goes for interest income from private mortgage lending or rental income earned while owning the property.

How to Buy Real Estate in an IRA

The most straightforward way to invest in real estate inside a self-directed IRA is to open and fund the account and then purchase the property, supply money for a private mortgage or make other real estate investments with cash directly from the IRA.
Clients could partner with others, including a spouse or other disqualified individuals, use a non-retirement account or use personal funds as long as this is treated as a new transaction and all aspects of ownership are accurately accounted for.
Financing with a non-recourse loan ensures that if the client’s IRA defaults on the loan, then the lender’s only recourse will be to repossess the property that was financed. This financing could trigger unrelated business taxable income.
Establishing an LLC owned by the IRA provides clients with checkbook control over the assets in the self-directed IRA and makes their transactions less reliant on the IRA custodian. This can also help reduce overall fees.

Before investing with these or other methods inside the IRA, be sure that clients have looked at the pros and cons and that they have consulted with tax and legal counsel as needed.

Also work with clients to ensure that they have their self-directed IRA with a custodian who is focused on self-directed retirement accounts and who offers reasonable fees and other services that may be needed.

Cautions With Real Estate in an IRA

There are some potential downsides, or at least cautionary aspects, to holding real estate investments inside a self-directed IRA or other type of self-directed retirement account.

One key rule associated with holding real estate inside an IRA is the rule against prohibited transactions. There are a number of ways to violate this rule, and the potential consequences can be devastating financially. 
Buying real estate inside an IRA works best when clients pay cash for the property. The transaction can be financed via a mortgage, but there are some rules that apply. One thing to be cognizant of is unrelated business taxable income, which can be triggered by financing a real estate purchase inside an IRA with a mortgage. 
Liquidity can be another issue. While investments held inside a self-directed IRA may have a long time horizon, clients may have a need for some liquidity inside their IRA. This may be the case if they need to take required minimum distributions or perhaps need funds from their IRA as part of their retirement income plan. It’s important to work with clients considering holding real estate assets inside their IRA to ensure this will not create any liquidity issues across their IRA and retirement account holdings.

Prohibited Transactions

A common prohibited transaction related to real estate is that disqualified persons under Internal Revenue Service rules cannot use or directly benefit from the property while it is held inside the IRA. Disqualified persons include the IRA account holder, a spouse, children, siblings, nieces/nephews, parents and grandchildren, among others.

An example of a prohibited transaction might be clients buying a rental property in the college town where one of their children goes to school because they think it will be a good holding. They cannot allow children to use the property while attending school or at any other time.

It is also critical that all expenses to repair and maintain property held in an IRA come from the IRA and not from clients’ non-IRA assets. Related to this, they cannot do any repair work on the property themselves; this must be performed by an unrelated third party, and the work must be paid for out of the IRA.