Property Investing Basics: Important Facts about Buying Real Estate with a Self-Directed IRA
Regardless of how experienced you are, real estate investing comes with a learning curve—a curve can be even steeper when buying property for the first time using a self-directed IRA.
Many self-directed IRA owners buy an investment property with their IRA funds because doing so comes with certain tax advantages. For example, with a Roth or traditional IRA, you can benefit from tax-deferred income and profits on your real estate investment until you make withdrawals.
But it’s important that you understand certain rules and be aware of certain facts, especially those that could potentially void these IRA tax benefits or result in penalties. Below are seven rules and best practices that first-time IRA real estate investors should be aware of:
1. You cannot live in the property. One common question we receive from first-time IRA real estate investors is whether they can purchase a property to live in using self-directed IRA funds. The answer is no. Buying property with IRA dollars for your personal benefit is considered by the IRS to be a prohibited transaction. No disqualified person, including you, can use the property. That means a disqualified person cannot live in or stay in the investment property. IRS rules dictate that you may not benefit personally from an investment held in your IRA. The same restrictions apply to your children, parents, your grandparents or any other "disqualified person" as defined by the IRS. When buying real estate with your IRA, the property is meant to be for retirement investment purposes only and cannot be used for personal benefit.
2. Conduct thorough due diligence. Remember: A self-directed IRA is just that—self-directed. That means that as the account owner, you are responsible for all of your investment choices. An IRA custodian like PENSCO does not provide any investment, tax or legal advice on the purchase. To that end, it is crucial that you conduct thorough due diligence and/or work with a financial or tax professional if needed before buying an investment property to hold in your self-directed IRA.
3. Don’t collect commission. You are not allowed to earn personal compensation on any self-directed IRA investment. That means that if you are a real estate agent, you cannot receive a commission or compensation on the purchase or sale of a property in your IRA. In addition, no disqualified person can make a commission for buying or selling property in your IRA.
4. Do not break a sweat. As a real estate investor, it may be tempting to try to save money by conducting any needed repairs on the property yourself. However, that is forbidden. When investing in real estate with your IRA, your IRA owns the property—not you. Rules and regulations prevent you (or any disqualified person) from personally performing work on the property, such as installing new carpet or cutting the lawn.
5. Ensure your IRA has sufficient funds to pay expenses for property. With any direct real estate investment made in an IRA, all expenses, maintenance costs and property taxes must be paid with funds from the IRA. You are not allowed to pay bills related to the investment property with your personal checkbook, personal savings account or personal credit card. If a contractor performs repairs on your investment property, the contractor needs to invoice your IRA — not you — directly for the cost. And don’t forget about your earnest money deposit. That must also be paid with cash from your IRA.
6. Fill out your deed and tax bill correctly. Because property taxes for the property must be paid with IRA cash, it is crucial that your paperwork is set up correctly. If you are purchasing property through your PENSCO IRA, the name on the deed and tax bill should be listed as “PENSCO Trust Company, LLC Custodian FBO [Your Name] IRA” and the address on your property taxes is PENSCO Trust Company, PO Box 173859, Denver, Colorado, 80217. PENSCO prefers the address on tax bills is PENSCO’s address so there is no confusion about where tax bills should be delivered. PENSCO can coordinate that payment with you when the bill is received. This enables you to avoid the possibility of accidentally paying taxes with personal funds. The same is true if you’re using a property manager—which we highly recommend. The property manager can have the tax bill sent directly to them and they will pay the tax and other expenses with income from the property.
7. Beware of the possibility of taxes. Yes, as I said earlier in this post, investing in real estate with an IRA has unique tax advantages. But there are also certain instances in which income generated by an investment property can trigger a taxable event in your IRA. If your property is financed or partially financed using a non-recourse loan, or acquired via a pass-through fund, your real estate investment could generate Unrelated Business Taxable Income, or UBTI. (This blog offers more details on UBTI.) It is highly recommended that you consult with a tax professional before making a property investment to determine if your IRA might be subject to UBTI.
While this property investing blog is far from exhaustive, it highlights the importance of educating yourself about the rules of self-directed IRA property investing before making any investment. Failing to follow IRS rules and regulations could lead to penalties or having your IRA loose its tax-advantaged status resulting is adverse tax consequences.
To learn more about using your self-directed IRA to invest in real estate, please download our guide.
This Blog does not provide investment, tax, or legal advice nor does it evaluate, recommend or endorse any advisory firm or investment vehicle. Investments are not FDIC insured and are subject to risk, including the loss of principal.
PENSCO Trust Company performs the duties of an independent custodian of assets for self-directed individual and business retirement accounts and does not provide investment advice, sell investments or offer any tax or legal advice. Clients or potential clients are advised to perform their own due diligence in choosing any investment opportunity as well as selecting any professional to assist them with an investment opportunity. Alternative investments are not FDIC insured and are subject to risk, including loss of principal. PENSCO is indirectly affiliated with a registered broker dealer and with a licensed small business investment company through Opus Bank (“Opus Affiliates”). Other than the Opus Affiliates, PENSCO is not affiliated with any financial professional, investment, investment sponsor, or investment, tax or legal advisor.