Real Estate

Real estate has become an increasingly popular investment for a growing number of Americans, due in large part to the consistent property appreciation and rental income that it promises.

Many people do not realize that they can invest their retirement in real estate; as a result, they purchase real estate without reaping the tax benefits of a 401k or IRA.

With a self-directed IRA, you can invest your retirement plan in real estate with several significant advantages, enumerated below.

Delayed taxes on investment gains

When you invest in real estate outside of a retirement plan, you owe tax right away on your rental income. When you sell the property for a gain, you’ll also owe taxes on your gain even if you plan on reinvesting that money in other real estate investments. An IRA delays taxes on your real estate income as long as you keep the money in your retirement account. This can help you earn a higher after-tax-return on your real estate portfolio.

Tax-free growth through a Roth IRA

If you invest through a Roth IRA, your investment earnings are tax-free when you take a withdrawal after the age of 59 1/2. By investing in real estate with a Roth IRA, you will not have to pay taxes on your rental income, your capital appreciation, or your gains from selling a property. In exchange, you do not receive a tax deduction for your contributions into the Roth IRA like you would with a Traditional IRA. However, with a large real estate investment the tax-free growth offered on a Roth IRA may be a better incentive than the initial tax savings on a Traditional IRA because gains in a Traditional IRA are taxable when you start to make withdrawals during retirement.

Leveraged growth

When you invest in real estate, you do not have to pay off the entire purchase at once. You may choose to pay off a portion of the cost and then take out a mortgage for the rest. As such, you can leverage your money through borrowing to earn a higher return. For example, if you put down $100,000 to buy a $250,000 property, your rental income will be coming out of an asset worth $250,000. Even when you take into account the borrowing costs, your return should be higher than if you had just bought an asset worth $100,000– and even better, that higher return is growing tax deferred in your IRA.

Upon purchasing real estate with a mortgage in your IRA, the mortgage can’t be titled in your name; instead it must be titled in the name of your IRA. Furthermore, it must be a non-recourse loan which means the loan is only backed by the value of the real estate that it’s paying for. Therefore, if you default on the loan, the lender is able to seize the property, but your other assets or personal credit score won’t be affected. Thus, while a non-recourse loan may charge a higher interest rate than regular mortgages, it also enables you to better protect your finances.

Protection against inflation and market volatility

The real estate market tends to be more stable than the stock market, as the real estate market lacks the same daily volatility of stocks. As a result, many view investment in real estate as a less stressful and lower-risk opportunity to invest retirement savings. Furthermore, real estate returns historically outpace inflation, allowing your retirement spending power to grow.

Rental income

When you purchase real estate property, you can rent it out for steady rental income. This rental income can then be used to pay off the mortgage and other expenses on your investment property, meaning you just need to come up with the down payment. Any extra rental income can stay in your IRA, where it will grow tax-deferred, and can be used for future investments. When you retire, you may continue to receive rental income to supplement your other savings.

A chance to pay for your dream retirement home

Do you have a dream retirement home in mind? Then your IRA can help you finance that dream. By purchasing retirement property through an IRA, you can use the property’s rental income to pay off the mortgage, as the IRA tax savings will allow you to do so quickly and effectively. When you’re ready to retire, you can withdraw the property title from your IRA and then move into your new home.

If you wait until you are at least 59 ½ to take the property out of your IRA, you’ll avoid the 10% early withdrawal penalty. In addition, you can’t live on the property while it’s still owned by your IRA, as this can lead to tax problems; however, nothing’s stopping you from driving by and seeing your future home, knowing that it’s steadily being paid off with your rental income.

If you’re going to invest in real estate, why not invest with all the possible tax benefits? By using your IRA benefits to their fullest, you can make real estate a more effective part of your retirement plan.

The flexibility of a self-directed IRA can be a great thing. It gives you the opportunity to make investments that you might not be able to make through other retirement plans. But the ability to go after a broader set of investments could also land you in trouble with the IRS if you aren’t careful and stay up to date on the rules. And the ramifications could be serious – if the IRS voids your account because of non-compliance, you would be forced to withdraw all funds and pay income tax on the entire balance (plus a potential 10 percent penalty if you are younger than 59 ½).

Here are some common mistakes self-directed IRA investors make. Are you headed toward any of these pitfalls?

1. Personally guaranteeing debts in the IRA

This rule can be tricky and you might not even know you are breaking it. For example, if you buy investment real estate for your account and take out a mortgage on the property, you are not allowed to guarantee the mortgage with your personal assets.

Another rule-breaking scenario would be if you invest through your IRA with a broker that requires investors to make up shortfalls in their investment accounts with their personal assets. (Some brokers require this). Signing this type of agreement would be a violation under self-directed IRA rules and the IRS could void your account.

2. Making deals with “disqualified persons”

The IRS has strict rules around who you can and cannot make business dealings with under your IRA. “Disqualified persons” in this case includes family members, friends and other people with whom you have a prior personal relationship.

This rule is in place to stop people from making the kind of sweetheart deals that could abuse the tax advantages under your IRA. For example, someone could use an IRA to buy a piece of real estate at a steep discount from their parents and later sell it for a huge gain while avoiding taxes.

It’s best to avoid personal deals altogether – even if you make a deal with a friend or family member that is completely fair and true to market conditions, the IRS could still void your account.

3. Investing in non-approved assets

While the self-directed IRA allows a large list of alternative investments, there are still some investments that are excluded. This includes most collectibles like antiques, stamps, gems, artwork, and rugs.

Other categories carry specific exemptions. Only certain types of precious metals are allowed on the self-directed IRA investment list. Most, but not all gold coins are acceptable. For example, if you want to buy gold coins, you can buy American Eagle and Canadian Maple Leaf gold coins, but not the South African Krugerrand.

If the IRS catches you investing in a non-approved asset, you will be forced take out the asset as a distribution and you will owe taxes on the amount of the withdrawal.

4. Mishandling improvement and repairs to real estate

There are specific rules about how you pay for repairs or improvements to a piece of real estate in your self-directed IRA. Paying for these repairs out-of-pocket or out of your personal assets is not allowed, and the IRS could force you to withdraw the real estate from the IRA. Instead, you must hire someone else to handle this work for you using funds from your self-directed IRA.

Too many investors run into trouble simply because they don’t understand the rules for self-directed IRAs. Remember to do your research before making investments with your IRA.

The Advantages Of Investing In Real Estate Through Your IRA