Investing in Rental Properties Through a Self-Directed IRA

Thinking about investing in rental properties through your IRA?  You've come to the right place.  We will answer all of the key questions you may have about this strategy.

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The information contained in this post is for informational purposes only. It is not a recommendation to buy or invest, and it is not financial, investment, legal, or tax advice. You should seek the advice of a qualified professional before making any investment or other decisions relating to the topics covered by this article.

Let's start with a brief introduction to the IRA.  

An Individual Retirement Account (IRA) is a tax-advantaged savings account which allows you to save money for retirement.  It comes in two varieties.  A traditional IRA and a Roth IRA.    

What is a Traditional IRA?

A traditional IRA is a tax-favored account that allows you to make pre-tax contributions to your IRA Account.  Essentially, this means that your contributions are not taxed for that year. 

Your assets in the traditional IRA are allowed to grow tax-free and the only time you are required to pay taxes on the money in your traditional IRA is when you withdraw the funds from your account.

If you withdraw assets from your traditional IRA before age 59.5, you will be taxed and also assessed a penalty of 10% on such withdrawals, unless you meet certain exceptions.

What is a Roth IRA?

A Roth IRA is a tax-advantaged account that allows you to make after-tax contributions to your IRA Account.  This means that your contributions will be taxed for that year. 

But your assets in the Roth IRA are allowed to grow tax-free and after age 59.5 you may withdraw the funds from your Roth IRA tax-free. 

You may also withdraw the contributions portion of your Roth IRA at any time and with no penalty.

If you withdraw the earnings portion of your Roth IRA before age 59.5, you will be taxed and also assessed a 10% penalty on such withdrawals.

The Real Estate Angle

Many people know about the tax benefits of IRAs.  But there’s one feature of the IRA that almost no one knows about – its potential application to rental property investing.   

That’s what you came for, so let’s get into it!

Can You Use Your IRA to Invest In Rental Properties?

You can use your IRA to invest in rental properties so long as you buy them through a “self-directed” IRA.  A self-directed IRA can be established by rolling over funds in an existing IRA account to a new account that allows self-directed investments in real estate.  Self-directed IRAs may be traditional or Roth IRAs

You need to find a custodian specializing in self-directed IRAs (or SD IRAs, for short) to open up this type of account.  We’ll go into the account set-up process and the various types of accounts that are available later in the article.

Once the rollover is done, you can use money in your SD IRA account to buy rental properties.

When investing in rental properties this way, you need to follow the IRS’s prohibited transaction rules and unrelated debt financing or “UDFI” rules (if you finance the rental).  More on that later.

Can You Use Your IRA to Flip Properties?

You can use your IRA to flip properties so long as you do so through a self-directed IRA.    

Like with rental property investing, flipping activities must comply with the IRS’s prohibited transaction rules and UDFI tax rules.   

How Do You Set Up a Self-Directed IRA?

The first step in setting up a self-directed IRA is to find a qualified custodian that administers self-directed IRAs and permits investments in rental property through such IRAs. After finding a suitable custodian you will need to open up a self-directed IRA account with them and fund the account either through a roll over of existing IRA funds or through a direct IRA contribution.  

A simple google search of “self-directed IRA providers for rental property investors” pulled up a list of providers.  You should go deeper than that, but this list might be a good place to start.    

As you look at providers, you will notice that there are two types of accounts that you can set up for your self-directed IRA.  The first is a Custodian Controlled Account and the second is a Checkbook Control Account.  

There are important differences between these two, so we’ll explore the features of both.

What is an IRA Custodian Controlled Account?

An IRA Custodian Controlled Account is a self-directed IRA Account where the custodian administers the funds in an IRA and takes direction from the IRA owner on investments. The IRA owner does not have direct control of funds in the IRA because the custodian controls those funds, including withdrawals from the account.  

You may need to get the custodian’s approval each time you want to make an investment and wait until they release the funds, all of which can take time.  They also typically charge you for each transaction.  

It’s a bit clunky for rental property investors because you have a lot of transactions happening in relation to your rental properties and you need to go to your custodian each time to get needed funds.  There is a better option – the Checkbook Control Account.  

What is an IRA Checkbook Control Account?

An IRA Checkbook Control Account is a self-directed IRA Account where the owner of the IRA has full control over the IRA funds.   The owner will not need approval from the custodian to make investments through the IRA and will not need to wait for the custodian to disburse funds in connection with such investments.  

It’s called checkbook control because you control the checkbook. 

Setting up this type of account requires a bit more work.  First, you have to form a limited liability company (LLC) that opens up a business checking account.  The funds in your IRA will be transferred to the LLC’s account.  

The LLC can then use those funds to make rental property purchases and handle transactions associated with that property.

Benefits of Investing in Rental Properties Through Your IRA

The primary benefit of investing in rental properties through a self-directed IRA is the significant tax advantages may be applied to the rental property investment.  A secondary benefit is the availability of financing for rental properties purchased through an IRA.  A third benefit is the ability to begin or expand a rental property portfolio through a new funding source.

Tax Advantages of Investing in Rental Properties Through Your IRA

IRAs offer significant tax benefits.  These benefits will flow through to your rental property investments held in your SD IRA. 

If you have a traditional version of the SD IRA, then contributions you make to it will be tax-deductible and the assets in the SD IRA will be allowed to grow tax-free (including rents, appreciation, and even capital gains on sale of the property).  You will only be required to pay taxes when you withdraw. 

If you have a Roth variant of the SD IRA, your contributions will not be tax-deductible, but you will enjoy tax-free growth and your withdrawals in retirement will be completely tax free.  

So you will enjoy the same tax free growth potential as the traditional IRA version, but once you retire all of the rental income will come to you tax-free.   

Benefits of Financing Rental Properties That You Buy Through Your IRA

The main benefits of financing rental properties that you buy through your self-directed IRA are: (i) you can purchase more properties with the same amount of funds and (ii) your rental properties will be positioned to generate higher returns because of their leveraged status. 

I discuss in greater detail the benefits of leverage in rental property investing in this article.  Essentially, you will be able to magnify returns on your investment because you will need to put less money down to purchase the rental property. 

We’ll cover more on the topic of financing below.

Untapped Funding Option

Another benefit of investing in rental properties through your IRA is that you can expand your rental property portfolio in a way that you might not have imagined possible.  Most people think of funds in their IRA as reserved only for investments in traditional brokerage firm offerings, like stocks, bonds, mutual funds, and ETFs.  

They do not realize that you can convert it into a powerful real estate investing tool.  

When you combine the tax benefits of the IRA with the natural wealth-building properties of rental real estate (cash flow, appreciation, debt paydown, leverage, etc.), you get a really potent investment vehicle.

Investing in Rental Properties Through Your IRA Offers Diversification

A common reason why people choose to convert their IRA to an SD IRA is because they want to diversify their investments.  That is a completely rational perspective and it is one of the reasons why I got into real estate investing in the first place.  

An SD IRA will certainly do the trick here.  Not only will it give you substantial diversification through real estate, it is a natural vehicle to invest in other exotic asset classes if you want to expand your scope of investing.

Investing in Rental Properties Through Your IRA Offers Greater Stability

This is really related in some ways to diversification, but real estate (especially rental property investing) generally does not suffer the same wild swings in valuation that the stock market experiences. 

Since investing in real estate, I have not had a sleepless night worried about what will happen to my rental property investments.  That fear just doesn’t exist because if you are prudent in your rental property investing, you can enjoy a very stable cash flowing asset that can be a perfect fit for your retirement account.

What Are the Risks of Investing In Rental Properties Through Your IRA?

The main risk of investing in rental properties through an IRA is violating IRS rules on prohibited transactions.  If those rules are not followed, the IRA could lose its tax-advantaged status, leading to potentially significant tax liability.

There are other risks and drawbacks as well (which we will cover), but let's start with the one that matters the most.

Prohibited Transaction Rules For Rental Property Investing Through IRAs

If you are going to use a self-directed IRA to invest in rental properties, you will need to navigate complex tax requirements contained in Section 4975 of the Internal Revenue Code.  

You should consult with your tax advisor to understand these requirements, but the key principle is that there cannot be any self-dealing or personal transactions (this also applies to family members too).  

For example, you can’t use funds from your IRA to purchase real estate for yourself or any other disqualified person (e.g., family members).  You can’t live on the property nor can family members.  In short, you and your family cannot receive any direct or indirect benefit from the investment. 

You also can’t lift a finger to fix anything or perform any type of work on the property – you must hire someone to do that.

I found this handbook by a lawyer specializing in this area to be a very helpful summary of the requirements around prohibited transactions. 

Less Flexibility To Put Money In If Needed

When I first set up my SD IRA, I invested as much of the money as I could into three rental properties and left only a modest amount in cash.  It worked out, but in hindsight, that was taking a big risk. 

That’s because you have limits on how much you can contribute to your IRA each year.  So if an unexpected large expense comes along and you can’t cover it with the funds on hand, you are kind of stuck. 

You can’t just whip out your personal credit card and pay it.  That would be considered a prohibited transaction and you could face serious tax consequences if you do that.

So make sure you have a healthy buffer in your IRA LLC’s account to cover expenses that may come along.

The final drawback of investing in rental properties through your SD IRA is that there are UDFI rules that apply if you get a loan to buy the rental property.  We'll cover that and more in the financing below, so let's get into it.

Can You Finance Rental Properties You Buy Through an IRA?

Rental property purchased through a self-directed IRA may be financed, but there are limitations.  First, the financing must be non-recourse. Second, there are few lenders offering this type of financing and the terms of such financing are typically not as attractive as terms offered through standard residential mortgages.  Third, rental income on financed rental properties will be subject to UDFI rules and taxed accordingly. 

No Recourse Loan

If you want to borrow money to buy your rental property, you must get a non-recourse loan.  This is a loan where the lender can only go after the secured asset (in this case, the rental property).  

Few Lenders and Tough Terms

While getting a non-recourse loan sounds good on the surface, it means that lenders are reluctant to operate in this space and if they do, they will not offer great terms.

You will likely need to put a lot down (like 40-50%) and will pay a much higher interest rate.  Their underwriting process is like what you would go through for a commercial loan – they look at your cash flow and have certain ratios (debt service coverage ratios) you need to meet.

Your Rental Income Will Be Subject to UDFI

I mentioned UDFI earlier.  That comes into play here.  If you choose to finance your property, then some portion of the income that you make on that property will be taxed as UDFI.  

How much tax you will need to pay is based on a proportional analysis.  So if you finance 50% of the purchase price then 50% of the net income will be taxed. 

For all of these complications, you do get a reward.  You can enjoy that sweet leverage on your investment.  It will amplify your returns in a way that is just not possible through your normal IRA.

Conclusion

Investing in rental properties through your IRA can be a great way to expand your real estate portfolio in a tax-advantaged way.  I hope this guide has given you some food for thought. 

Let me know your thoughts on this investment strategy.  Do you think it can be a good way to invest in real estate or is it too risky?  Have any of you tried this method of investing?  Please let me know in the comments section below.

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