An IRA, or individual retirement account, may already play an important role in your overall retirement plan. What you may not realize about this kind of tax-advantaged plan, however, is that you can use it to purchase real estate and further grow your savings. Let’s talk about what that process entails, why a real estate IRA is worth considering and some important pitfalls to keep in mind. Consider working with a financial advisor if you’d like to explore investing in real estate.
The Value of an IRA
An IRA is a financial account designed to help you save for retirement in a tax-advantaged way. You can find these accounts offered by many different financial institutions and brokerages, offering a wide variety of investment opportunities. Unlike a 401(k) plan, an IRA does not need to be tied to an employer.
The IRS sets an annual limit each year, dictating how much can be contributed to your IRA. For 2023, this limit was $6,500 ($7,500 for participants 50 and older) or your annual taxable income – whichever is less. This increases to $7,000 and $8,000, respectively, for 2024.
Depending on your situation, there are three different IRAs to choose from: a traditional IRA, a Roth IRA and an IRA CD. Each provides owners with different benefits, such as being able to save and invest money tax-free or tax-deferred.
Money held in an IRA can be put to work in a range of investments, including mutual funds, target date funds, exchange-traded funds (ETFs), individual stocks, bonds and even certificates of deposit (CDs). The growth of those investments can be held in the IRA until retirement age, when it can be withdrawn either tax-free or at your current tax rate, depending on the type of IRA you have.
Using Your IRA to Buy Real Estate
As mentioned, you can use your IRA to invest in several different funds, stocks and bonds. If you really want to diversify your retirement portfolio for the future, however, you may want to also consider investing your IRA savings in real estate.
Step 1: Choose a Self-Directed IRA
The first thing you’ll need to do is open and begin funding a self-directed IRA. These accounts, which are offered by select financial institutions, allow alternative investments for your retirement savings. Not all banks and brokerages offer self-directed IRAs, so you may need to shop around.
It’s also important to note that when buying real estate in a self-directed IRA, your IRA will own the asset, not you personally. Because of this, there will need to be a very clear division between your actions and your funds and those belonging to your IRA.
Step 2: Choose a Custodian
One of the biggest differences between self-directed IRAs and traditional or Roth IRAs is that a self-directed account is managed by a custodian. This fee-based custodian will facilitate all transactions involving your new IRA, ensuring that all IRS regulations are followed and that proper financial reporting is completed. If these rules aren’t followed precisely, you could find your IRA disqualified. That would be detrimental to your future retirement savings and also trigger a taxable event for your funds.
While your custodian will manage the technical side of your real estate IRA investments, they will not serve as a financial advisor or otherwise guide you in your investment decisions.
Step 3: Choose a Property
Any property you choose to buy with your real estate IRA will need to be an investment property. This means that it cannot be a vacation getaway for your family, a second home or even a property for your parents. Improper use of your real estate IRA’s property could have serious financial implications.
To avoid these, ensure that the investment will not be utilized by any “disqualified” individuals. According to the IRS, this includes your spouse, parents/grandparents, siblings, property co-owners and many other members of your extended family, such as those of “lineal descent” (children, grandchildren, great-grandchildren and their families).
Step 4: Make Your Purchase
Buying real estate with your IRA can be a bit tricky. Remember how we mentioned that your self-directed IRA will own the property, rather than you? Well, for this reason, your IRA may have a tough time getting approved for a mortgage loan to purchase your investment property. As a result, many investors opt to simply purchase the property outright and in total. Depending on your IRA balance, this may limit your investment property options.
Step 5: Managing the Property
Your investment property will have taxes, maintenance and management expenses over time. However, your IRA needs to cover these, since it technically owns the real estate… not you. This can be both good and bad.
It may be nice to not have to cover these expenses directly out of your own pocket. It can also present a problem if your property incurs a very large expense (think new roof, foundation repair, etc.) and you don’t have enough in your IRA to cover those expenses. In that case, you’ll need to contribute additional funds — but if you contribute more than the IRS annual limit, you’ll also incur penalties.
Also, don’t forget that every dollar withdrawn from your IRA before retirement is a dollar that won’t grow over time. Depending on how much money needs to be withdrawn and when this can impact your retirement savings.
Step 6: Benefit from the Property
Because your IRA owns your property, your IRA will also benefit from any growth. This means that when you eventually sell your real estate, the gains will be deposited into your IRA. This can be a great way to boost your retirement savings without the same tax implications as buying and selling on your own.
Requirements of Real Estate IRAs
Real estate IRAs have a few very important requirements, besides those mentioned above. For one, you’ll need to open a self-directed IRA. Your typical Roth or traditional IRA will not work here; instead you’ll need to open a self-directed account with a custodian. Also, your real estate cannot be used by any disqualifying individuals.
If your property is intended for or utilized by individuals close to you, you may disqualify your account and trigger certain taxes. These disqualifying individuals include your immediate family, spouse, parents and grandparents or other majority-share owners in the property.
Finally, your IRA will need to manage the property entirely. Your real estate IRA technically owns the property, so it will also need to manage the property. This means that you will need to cover expenses with IRA funds – not savings accounts or money from other accounts.
Tax Implications of a Real Estate IRA
Since you don’t technically own the property purchased through your real estate IRA, you also don’t get the tax benefits of the property.
Unlike privately owned property, you are not eligible for tax deductions on your real estate IRA. Deductions for property taxes, qualifying expenses or depreciation are not allowed on your taxes. You also cannot deduct mortgage interest; however, since most investors will purchase their IRA-held property outright (without the use of a mortgage loan), this is usually a moot point.
With that said, there are still the usual IRA tax benefits in place. Your contributions or withdrawals will be either tax-deferred or can grow tax-free, depending on your IRA’s structure.
Advantages of Buying Real Estate With an IRA
Thinking about buying real estate with an IRA? Here are four common reasons to consider it:
- Any sort of portfolio diversification can help you hedge market downturns. By adding real estate through your IRA, you may make your portfolio more secure.
- Since your property will be managed by a custodian and owned by your IRA, you don’t have to worry about out-of-pocket expenses and taxes associated with owning an investment property.
- Real estate often appreciates at a more predictable rate than other investments, giving you a steady vehicle for retirement growth.
- If your investment property collects rent, this income can grow within your IRA tax-free.
Disadvantages of Buying Real Estate With an IRA
You may also want to consider these five things before buying real estate with an IRA:
- You Need a Custodian: A custodian will need to manage your self-directed IRA, including any real estate ventures you want to pursue.
- You Can’t Use the Property: The investment property cannot be utilized by you, your family members, your business or other partners without being disqualified.
- You Can’t Pay for Expenses Out of Pocket: Your IRA owns the property, so any necessary repairs or expenses will need to be paid by your IRA balance. This can affect your retirement savings.
- You Can’t Claim Deductions: Though you own real estate, you will not be able to claim any of the tax deductions offered. These include depreciation, property taxes, eligible expenses or mortgage interest.
- It’s Hard to Find a Mortgage: Few lenders are willing to offer mortgage loans to IRAs, so most buyers will need to pay cash for this real estate. Additionally, if you don’t have enough saved and encounter a large expense, you could find yourself in hot water.
Adequately saving for retirement usually requires a multi-tiered approach. Purchasing real estate with an IRA is one option to consider, allowing you to not only diversify your retirement portfolio but also encourage even greater growth of your savings. However, this approach isn’t for everyone, as there are some very important financial caveats to keep in mind. If you’re not sure whether buying real estate with an IRA is right for you – or how to go about doing so properly – consult with a financial advisor.
Tips for Investing and Retiring
- There are several ways that you can use an IRA in your personal finances. A financial advisor can provide insight and guidance about these options. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three 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.
- Want to take a look at what your portfolio will look like in a decade? SmartAsset’s investment calculator can help you do just that. Enter how much you have invested, how much you’re contributing and what rate of return you expect. We’ll then show you your investment growth five, 10 or even 30 years into the future.
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