Ask an Advisor: Can I Invest in a Real Estate Project Within My Roth IRA? Will the Future Growth and Income Be Tax-Free?

I own a small patch of land, mortgage free and zoned for commercial use. I’d like to hire a contractor to put a commercial building up on the property. Rather than finance it with a bank and have them profit from the interest income I’d like to use my Roth IRA to invest in the project and benefit from future tax-free income and appreciation.

I understand the Roth can’t issue a loan to me but I’d like the Roth to finance the construction as an investment, then have the project as an asset in my Roth IRA to benefit from future tax-free income and appreciation. Is that possible? A self-directed IRA? How would I go about this?     – John

The short answer is yes, you could possibly do this through a self-directed Roth IRA if you were willing to give up ownership of the land. If you explore that route, I strongly recommend you engage an advisor that is well-versed in the rules and has experience handling them because any misstep could lead to disqualification of your IRA.

For questions about IRAs and retirement planning strategies, consider speaking with a financial advisor. This tool can connect you with a fiduciary advisor for free.

What Is a Self-Directed Roth IRA?

A self-directed Roth IRA is simply a Roth IRA that allows you to invest in a broader range of assets than a typical IRA. Most Roth IRAs offered by large custodians typically restrict investors to publicly traded securities, including stocks, bonds and mutual funds. By contrast, a self-directed IRA allows investors to allocate funds to a wider range of alternative investments, such as real estate, private companies, private lending arrangements and limited partnership interests.

Although the investment options may be different, the tax treatment is the same as any other Roth IRA. Contributions are made with after-tax dollars, and qualified withdrawals in retirement are generally tax-free. All of the growth and income generated inside the Roth IRA can still accumulate tax-free.

Through a self-directed Roth IRA, you can invest in assets like the real estate project you described. However, the IRS rules governing how those investments must be structured and handled are very important.

(And if you’re thinking about adding alternative assets to your retirement portfolio, consider talking it over with a financial advisor first.)

Adhere to the Prohibited Transaction Rules

The most important rule to remember is avoiding prohibited transactions. IRS regulations prohibit your IRA from conducting transactions with you or specific related parties, known as “disqualified persons.” This category includes you, your spouse, your lineal ancestors (parents and grandparents), your lineal descendants (children and grandchildren), and any businesses you control. ¹

Because of this, the IRA generally cannot lend money to you personally or invest in property that you personally own. If your Roth IRA were funding construction on land that remains in your name, that could potentially be viewed as providing a benefit to you personally, which may violate the prohibited transaction rules. I am not myself an expert on these types of transactions, so I don’t have a specific solution for you, but I do know that is a significant hurdle you would need to clear in order to make this work.

There are also operational rules to keep in mind. You generally cannot personally provide services to the project, perform labor or otherwise contribute “sweat equity.” All expenses related to the property must be paid by the IRA. Any income generated by the property must also flow back into the IRA. You also cannot personally use the property or lease it to your own business.

(Financial advisors have different areas of expertise, which is why it can be helpful to speak with several before settling on the one you feel can best deliver the services you require.)

Consequences of Violating These Rules

If the IRS determines that a prohibited transaction occurred, the IRA can lose its tax-advantaged status. In effect, the entire IRA could be treated as though it were distributed to you as of the beginning of the year in which the violation occurred. Any future tax-free growth that the Roth IRA would have provided would be lost.

Because of those potential consequences, anyone considering a self-directed IRA for real estate projects or otherwise should proceed carefully. Work with a knowledgeable custodian, attorney, or advisor who regularly deals with these structures and can help ensure the investment is set up correctly and remains compliant with IRS rules.

In the right circumstances, self-directed IRAs can be beneficial, but the structure and compliance requirements are complex. Most investors should seek experienced guidance rather than attempting this independently.

Bottom Line

You may be able to use a self-directed IRA to do what you mentioned. However, you’ll need to give up ownership of the underlying property to do so. Otherwise, you’ll be engaging in a prohibited transaction.

Roth IRA Tips

• A financial advisor can help you evaluate contribution timing options, consider asset allocation approaches aligned with your specific goals and weigh the pros and cons of a Roth conversion. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
• If you experience a year with temporarily reduced income, such as between jobs, during a sabbatical, or in early retirement, convert traditional IRA funds to your Roth IRA. You’ll pay taxes at your current lower rate while creating tax-free income for future years when you might be in a higher bracket. This strategy requires careful tax planning to avoid pushing yourself into higher brackets.

Brandon Renfro, CFP®, is a SmartAsset financial planning columnist and answers reader questions on personal finance and tax topics. Got a question you’d like answered? Email AskAnAdvisor@smartasset.com and your question may be answered in a future column.

Please note that Brandon is not an employee of SmartAsset and is not a participant in SmartAsset AMP. He has been compensated for this article. Some reader-submitted questions are edited for clarity or brevity.

Photo credit: Courtesy of Brandon Renfro, ©iStock.com/Richard Stephen