A self-directed individual retirement account, or SDIRA for short, is a retirement investment vehicle that allows you to save for the future in a tax-advantaged way. Like a regular IRA, you can choose a Traditional or Roth approach, depending on your income level and when you whether you want to pay taxes on your contributions or distributions.
But regular IRAs typically restrict you to investing in stocks, bonds, mutual funds and similar securities. If you want to put your retirement savings in alternative investments, such as privately-held companies, precious metals and real estate, you’ll need to self-direct your IRA.
Using a self-directed IRA to invest in residential or commercial real estate and other investments not allowed through regular IRAs has some significant benefits, but there are also drawbacks that could make it less appealing for many investors.
What are the pros and cons of self-directed IRA real estate investing?
If you’re considering using a self-directed IRA to invest in real estate for your retirement, there are likely some clear reasons why. Here are five benefits to the strategy.
Pro: Tax-free or tax-deferred account growth
While SDIRAs function a little differently than regular IRAs, they still offer the same tax benefits. This means that you can invest in real estate as you normally would, but your gains are tax-free or tax-deferred, depending on the type of IRA account you use.
A Roth SDIRA uses after-tax contributions, which means that you can’t deduct the money you invest in the tax year you contribute. However, your earnings will grow tax-free and when you take distributions from the account in retirement, you won’t owe any taxes on them.
On the flip side, a Traditional SDIRA allows you to deduct your contributions in the tax year that you make them. Earnings then grow tax-deferred, and any distributions you take in retirement will be taxed.
There are a lot of factors to consider when deciding between a Traditional or Roth self-directed IRA account, and it may be a good idea to consult a tax professional. But either way, there aren’t many other opportunities to invest in real estate in a tax-sheltered way.
Pro: Control over your investments
Unlike more traditional securities, investing in real estate allows you total control over your assets. This makes a self-directed IRA real estate strategy a good one for hands-on investors who want more than a passive approach to their retirement.
As the owner of the account, you get to decide what to do with your investments. For example, you can choose to make changes to the property or leave it as-is, rent or sell, fix and flip or maintain it as a landlord.
Pro: Investments get certain protections
If you run into financial troubles and need to file bankruptcy, the Bankruptcy Abuse Prevention and Consumer Protection Act allows you to exempt up to $1 million of your SDIRA funds. This means that creditors can’t lay claim to any of those funds.
You may also have some protection from certain types of court orders, depending on the state in which you live. For example, in California, you can exempt amounts from your SDIRA that are necessary to support you and your dependents in retirement.
That said, it’s a good idea to check the laws for your state, so you don’t end up with an unexpected surprise.
Pro: High return on investment potential
If you understand the real estate market well and know ways to reasonably reduce your exposure to risk, a self-directed IRA real estate strategy could allow you to earn a higher ROI than what you’d get with stocks, bonds and other traditional securities.
Of course, that doesn’t mean anyone can automatically expect a higher return. In general, real estate investing requires more hands-on work, and the more experience you have in the industry, the better your chances are that you’ll make more money.
Pro: Option to create an LLC
With self-directed accounts, you typically need to file paperwork with your account custodian — the company that holds your account and ensures it adheres to IRS regulations — every time you want to transact.
This means that if you want to purchase a property, send proceeds from a sale or whatever else, you’re at the mercy of the custodian’s processing times. Depending on their hours and backlog, it can be an incredibly frustrating experience.
Fortunately, it’s possible to create a limited liability company (LLC) for your SDIRA. Doing this gives you checkbook control, which means no waiting and also allows you to cut down on administrative fees (because you’re running the show, not the custodian).
Investing through an LLC can also provide other liability protections, though you should consult with a tax professional to better understand the LLC laws in your state.
Con: Paperwork and fees
There’s a lot of paperwork involved in creating an SDIRA and also to transact with the properties you purchase with it.
And while you can effectively cut out the middleman on processing transactions by opening an LLC, you’ll still need to get the SDIRA custodian to countersign all of the contracts you sign.
What’s more, the account custodian will charge fees to hold your investments and provide certain services to you. There are ways to save some money — again, through an LLC — but some fees you won’t be able to avoid.
Con: Regulations are complicated
Your SDIRA could be disqualified as a tax-advantaged account if you don’t follow all of the IRS regulations to a tee (we’ll cover those in a bit). Your custodian can help ensure that your account stays in line, but since you have a lot more control with an SDIRA than a regular IRA, there’s more room for error.
If your self-directed IRA is disqualified because of non-compliance, your account may be subject to taxes (Traditional only) and penalties.
As a result, it’s crucial that you learn the rules and regulations for buying, financing, managing and selling any property you invest in through your SDIRA.
Con: Unrelated debt-financing income
Although you generally don’t have to pay taxes on your earnings in an SDIRA, there are some situations where you do. Specifically, if your IRA owns property that has been financed, some of the income from the property is considered unrelated debt-financing income (UDFI), which is subject to taxes.
For example, let’s say you purchase a $200,000 home using $100,000 of your SDIRA funds and $100,000 in debt. Fifty percent of your net income each year would be considered UDFI and taxable since that’s the portion of the purchase you made using debt.
There are, however, some exceptions and other rules to know when it comes to UDFI, so consult with a tax professional to understand how it can affect you.
Con: Fluctuating market and liquidity
Like the stock market, the real estate market is prone to fluctuations. The difference is that stocks are much more liquid than properties. If there’s a down market, you can usually still find people willing to purchase a stock or bond. But if the real estate market slows, it can be challenging to offload a property.
This may not be a problem if you’re planning to purchase a home with your SDIRA and keep it as a rental property. But if you’re in the business of fixing and flipping homes, market fluctuations can make your life difficult.
Con: Expensive investment
Investing in real estate requires a lot of money, whether or not you’re using an SDIRA to do so. Closing costs on a home purchase can range from 2% to 5% of the home’s value, which can hit your wallet hard on more expensive properties.
Then there’s also the cost of a down payment, repairs, maintenance, upgrades, taxes, mortgage and homeowners insurance. If you don’t have the cash necessary to pay for these, using an SDIRA to invest in real estate may not be right for you. Of course, you can use your IRA to get an investment property loan to help cover the costs, but remember that a portion of the income you derive from the property may be considered taxable.
Stocks, on the other hand, can be very cheap. There are loads of share prices that you can buy for under $10 a piece, so it’s easy to get start with stock market investing. Many people get started with only $100 per month. You obviously can’t invest in real estate with that little capital.
Con: Third-party involvement
Investing in real estate can be challenging, but it becomes even more so when you involve self-directed IRA custodians. While you can form an LLC and take over checkbook control, you still need to report your transactions to the custodian for approval.
Depending on how willing you are to deal with a third party, this drawback may not be worth the extra value you gain from your capital gains growing tax-free or tax-deferred.
Self-directed IRA real estate rules
As previously mentioned, SDIRAs come with a lot of rules and regulations, especially if you’re planning to use your funds to invest in real estate properties. While it’s essential to work with your account’s custodian and a tax professional to make sure you’re complying with the IRS, here are some examples to give you an idea of what to expect:
- You can’t use an SDIRA to purchase or sell property owned by you or a disqualified person, which includes immediate family members and certain related trusts and business entities.
- You can’t gain “indirect benefits” from your SDIRA. In other words, any profits you earn must be used for your retirement. This means that you can’t benefit from the profits today, rent space from the building your SDIRA owns or anything else that could constitute indirect benefits.
- You may purchase real estate using SDIRA funds and debt from outside sources, but it’s not a requirement. Investments that use financing from outside sources may result in a portion of your income being subjected to UDFI.
- All of your expenses incurred for your investment properties, including but not limited to maintenance, repairs, improvements, insurance and property taxes, must be paid from SDIRA funds.
- All earned income from properties owned by the SDIRA must go back to the SDIRA.
Final word: Self-directed IRA for real estate investing
Getting a self-directed IRA to invest in real estate has a lot of benefits, and if you’re an experienced real estate investor who understands the market, setting up an SDIRA could be an excellent way to continue your investments with the benefit of tax-advantaged gains.
Remember, though, that SDIRAs have the same contribution limits as regular IRAs. For 2019 and 2020, the annual contribution limit is $6,000 (or $7,000 if you’re 50 or older). This means that it can take some time for some to build up a significant enough balance to make an SDIRA real estate strategy worth it.
However, also keep in mind that the contribution limit does not apply to rollover contributions. So if you already have a sizable 401(k), IRA or similar retirement account, you can roll it over into an SDIRA and start investing on a large scale immediately.
Regardless of what you do, take your time to do some due diligence. Understand how both the pros and cons of self-directed IRA real estate investing can affect you and your plans for retirement. Consider consulting a financial advisor to get an objective perspective.
Finally, keep the power of proper asset allocation in mind. Putting all of your money in one asset, whether it be real estate, stocks, bonds or anything else, can expose you to higher risk. By spreading out your retirement savings across multiple assets, you’ll be better diversified, which can limit your risk if one asset isn’t doing well.
As you keep these tips in mind, you’ll be in a better position to know how self-directed IRA investments can help you achieve your goals and whether it’s the best fit for your retirement strategy.
This article was originally written on December 27, 2019 and updated on January 31, 2021.