Is Buying Real Estate in an IRA a Good Idea?
Greetings! My name is Ben Sprague and every week I write about real estate and the economy. If you haven’t already done so, click Subscribe below to get my articles (for free) in your inbox each Sunday morning.
Disclaimer: the following is written for education purposes only and is not meant to be a form of specific financial advice. Each person’s circumstances are different. It is important to understand the risks and objectives of any investment or investment strategy prior to engaging in it. Consult a CPA, attorney, or licensed financial advisor when making financial decisions.
Is Buying Real Estate in an IRA a Good Idea?
There is a strategy that floats around the periphery of the financial planning industry that catches the eye of out-of-the-box types from time to time, and that is the idea of holding actual real estate within an Individual Retirement Account, more commonly known as an IRA. IRAs are, of course, typically used for investing pre-tax dollars in things like stocks and bonds, mutual funds, and ETFs and index funds with the investment gains and dividends growing tax-deferred until retirement. The same can be said of Roth IRAs, with the primary difference being the tax benefits of a Roth IRA are on the back-end upon withdrawal rather than on the front-end upon contribution. Indeed, investing in stocks and bonds and other similar things is how probably 99.9% of IRAs and Roth IRAs are handled. But what of the remaining 0.1%?
People may be surprised to know that the IRS does, indeed, allow IRA owners to hold actual real estate in their IRAs We are not talking here about holding a mutual fund or ETF that focuses on real estate-oriented companies or a publicly traded real estate investment trust (more commonly known as a REIT), but actual real estate like a rental property, commercial property, timberland, farmland, or raw land.
There is something intriguing and exciting about the idea of investing in real estate within an IRA: it’s almost like you’re outsmarting the system or something. Saving money in an IRA is a smart financial idea, investing in real estate is (usually) a smart financial idea, so combining the two must be especially wise, right?
Well, it gets pretty complicated.
The Guidelines
There are a lot of rules and requirements to keep in mind when investing in real estate within an IRA (or Roth IRA). The two most important are that 1) the IRA must be what’s called self-directed IRA and 2) the assets held within the IRA cannot ever be used for personal use.
On Item #1, a self-directed IRA is an IRA of which you yourself are the manager. You would need to find a custodian to hold the IRA and there are companies that specialize in this, but the custodian would not typically offer advice about the investment decisions; you are in charge. Most mainstream IRA custodial companies including Fidelity and Vanguard do not offer self-directed IRAs, so you have to go off the map a little bit. Companies that offer self-directed IRAs that can hold real estate are fewer and farther between, and there may be significant fees, start-up costs, and annual expenses that you should be mindful of. All that being said, self-directed IRAs also allow you to invest in other alternative investments like physical gold and other precious metals or commodities, which may also be an intriguing idea to some people (note: you can not invest in collectibles within a self-directed IRA. Some types of coins and metals require clarification about whether they are an investible hard asset or a collectible.)
On Item #2, just as you cannot access funds within a traditional IRA for personal use without triggering taxes and early withdrawal penalties (if you are younger than 59 1/2 years old), you cannot use or benefit from tangible assets held within a self-directed IRA. This means the real estate cannot be your personal residence, a vacation home, something like an AirBNB property that you also use yourself periodically, or a commercial property for your own business. If you do “use” the property even accidentally by staying in it temporarily, it is considered to be a withdrawal-triggering event with major tax consequences including potential penalties on top of income taxes.
A third related point to keep in mind is that you cannot buy a property to hold within an IRA from yourself or a family member. In other words, if you already own a property that you want to stick into an IRA, that transfer is not allowed; the IRA cannot buy the property from you and there is no mechanism to simply transfer it in. The IRA has to buy a property itself completely anew, and the transaction cannot be with yourself or a family member. So you also cannot buy a property from a parent or grandparent, for example, to be held in your IRA.
Those items noted above are the main ones to keep in mind, but there are many, many other things to be aware of as well. A mistake in even a small area can be extremely costly as IRA withdrawals, even accidental ones, are heavily taxed as ordinary income plus a 10% early withdrawal fee. These taxes and penalties can easily cost people 30-40% or more of the account value.
Other things to keep in mind include:
The IRA must pay for the property in cash, which requires a pretty healthy balance in the IRA.
Banks will not lend for purchases of real estate by IRAs. The primary reason is that IRAs are tax-protected vehicles, and banks cannot legally foreclose upon the assets in an IRA because it would trigger taxes and penalties to the IRA holder. Some off-the-grid hard money lenders may be willing to offer financing for IRA purchases of real estate, but it gets dicey.
Repairs and renovations must be paid for with funds held within the IRA. For this reason, IRAs need even some surplus funds in them beyond the purchase price. You cannot pay out of pocket yourself for improvements to the property even if it is your own IRA.
The actual repairs and renovations cannot be done by the IRA account holder; you must hire out. Otherwise it is considered to be a type of “self-dealing,” and is prohibited.
All rental or investment income must be kept within the IRA until after age 59 1/2. On a positive note, this income will grow and accumulate tax-deferred and the income itself can be used for improvements to the property. On the other hand, you cannot enjoy the benefits of this income until age 59 1/2 or later (the same way you cannot enjoy the financial gains in a more traditional IRA).
Apart from the start-up costs and ongoing fees of setting up an self-directed IRA, which are going to be much higher than they are for a traditional IRA, keep in mind that the legal costs for executing transactions with a self-directed IRA are also usually going to be higher. Transactions are just more complex this way. Additionally, real estate is far less liquid than stocks, mutual funds, ETFs, etc. If you need to access funds during retirement even after the early withdrawal penalty is no longer applicable, withdrawing from a self-directed IRA could be much more cumbersome.
Advantages and Drawbacks
The benefits of investing in real estate or other hard assets in a self-directed IRA include portfolio diversification. If you are a savvy real estate investor, holding real estate assets instead of stocks and bonds, etc., in an IRA or Roth IRA may be a good financial play. And, of course, investments within an IRA grow tax deferred. The rental income from an investment property, for example, would all be tax-free until retirement, and the capital gains from liquidating a property someday within an IRA would also be tax-free.
But the drawbacks are many, including simply having to keep track of so many of the rules and requirements above. One tiny slip-up could cost hundreds of thousands of dollars in taxes and penalties in a self-directed IRA with a large balance.
Another drawback is that although the income is tax-free, IRAs as non-taxable entities do not benefit from the tax deductions that typically come from owning real estate. Deductions that ordinary investment property holders benefit from for property taxes, utilities, repairs, mortgage interest, insurance, etc., are simply not relevant in this situation. They must be paid, of course, with the IRA itself being responsible for those costs; if an IRA is not paying the property taxes, eventually the city or town is going to come knock on the door. But there are no benefits to the IRA of deductibility. Since these deductions are often part of the “special sauce” that makes real estate investing financially viable to begin with, it is questionable whether forgoing them is even worth it.
On that last point, there is an opportunity cost to all of this as well. By that, I mean that even if investing in real estate within an IRA might be mathematically profitable, what about just investing those dollars into a traditional IRA instead and still investing in real estate or other assets outside of the IRA as normal. True, you would forego the financial benefits of investing in real estate within an IRA, but you could still invest in those assets outside of an IRA and enjoy the benefits of tax deductions while investing other financial assets in a more traditional IRA.
There is also the opportunity cost of time and energy. I would think just the time and stress of figuring out exactly how to do this all would simply not be worth it, nor would the overarching pressure to handle a property correctly within an IRA in order to not trigger taxes and penalties.
With that in mind, the types of real estate that might make the most sense to hold within an IRA are more passive investments that might traditionally have fewer deduction options anyway. Timberland comes to mind, or certain types of farmland or raw land. I myself have never really invested in precious metals or commodities, but these types of things, too, may make more practical sense to hold within an IRA. Rental properties or active commercial properties, on the other hand, seem less viable, in part because it is not as crucial to collect the income from these types of real estate in a tax-protected way because the IRA already allows for so many deductions and other tax benefits related to these types of properties.
So to conclude, investing in real estate within an IRA is an interesting idea and is worth kicking the tires on in part just to better understand it. There is a novelty to it that is really interesting to consider. However, the costs, legal and financial complexities, and opportunity costs make this a strategy that is not going to be especially viable or worth it to the vast majority of investors.
If you’re especially interested in the financial benefits and growth opportunities of investing in real estate, there are plenty of other ways to do it within an IRA or Roth IRA including REITs or mutual funds or ETFs that specialize in real estate. This has been a popular area of investing over the last decade, and investment options for investors ranging from the most savvy to the most beginner have proliferated. The Vanguards and Fidelities of the world all have options for investing in broad baskets of real estate, as would your friendly neighborhood investment advisor. Vanguard’s Real Estate Investment Fund has returned 9.03% since its inception in 2001, for example, all completely passive to the investor provided you are not staying up late at night stressing about the fluctuations. Investing in a Vanguard fund to get access to real estate is certainly a lower stress way to invest in real estate without actually owning the real estate and having to deal directly with repairs and renovations, tenant management, and the many various other issues that come with owning a property.
Ben Sprague lives and works in Bangor, Maine as a Senior V.P./Commercial Lending Officer for Damariscotta-based First National Bank. He previously worked as an investment advisor and graduated from Harvard University in 2006. © Ben Sprague 2023.