Can You Buy Real Estate With a Self-Directed IRA?

Real estate self-directed IRAs are a type of IRA that allows investors to include real estate as part of their investment vehicles. In this article, we consider how to buy real estate with your SDIRA and the rules you must follow, as well as the pros and cons of taking such a step.

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  • Written By
    Marguerita M. Cheng, CFP®, CRPC®, CSRIC®, RICP®

    Marguerita M. Cheng, CFP®, CRPC®, CSRIC®, RICP®

    CEO of Blue Ocean Global Wealth

    Marguerita M. Cheng, CFP®, CRPC®, CSRIC®, RICP®, is the chief executive officer at Blue Ocean Global Wealth. As a CFP Board of Standards Ambassador, Marguerita educates the public, policymakers and media about the benefits of competent and ethical financial planning. She is a past spokesperson for the AARP Financial Freedom campaign.

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  • Edited By
    Savannah Pittle
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    Savannah Pittle

    Senior Financial Editor

    Savannah Pittle is an accomplished writer, editor and content marketer. She joined as a financial editor in 2021 and uses her passion for educating readers on complex topics to guide visitors toward the path of financial literacy.

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  • Financially Reviewed By
    Chip Stapleton
    Chip Stapleton

    Chip Stapleton

    FINRA Series 7 and Series 66 License Holder

    Chip Stapleton is a financial advisor who has spent the past several years of his career working primarily in financial planning and wealth management. He is a FINRA Series 7 and Series 66 license holder and passed the CFA Level II exam in 2022.

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  • Updated: March 11, 2024
  • 10 min read time
  • This page features 8 Cited Research Articles

As investors seek to maximize returns for their investments, self-directed IRAs have become more popular.

Unlike traditional IRAs that limit your investment vehicles to stocks, bonds, mutual funds, exchange-traded funds (ETFs), real estate investment trusts (REITs) and certificates of deposit (CDs), self-directed IRAs (SDIRAs) allow you to explore alternative investments like cryptocurrencies, real estate, commodities and private placements. These non-traditional investment vehicles have been known to post higher returns than their traditional counterparts.

One such alternative investment is real estate. Many consider real estate as an opportunity to generate long-term, generational wealth. This is especially so for those who have experience buying and selling properties or those who have profitable knowledge of a particular local real estate market.

Though real estate is a good potential investment, it has its drawbacks. Among these is the problem of illiquidity, the possibility of making a loss on a property and the high cost of maintaining a property. When you own them in an SDIRA, these problems still exist.

Therefore, before choosing to have your self-directed IRA hold real estate, you must understand the pros and cons as well as the rules that you must abide by to avoid penalties.

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How Do You Purchase Real Estate With an SDIRA?

As real estate SDIRAs — SDIRAs that allow investment in real estate (single-family homes, apartment buildings, multiplex homes and all forms of commercial properties) — grow increasingly popular, many investors want to know how to buy real estate in their self-directed IRAs. There are a few steps you can take to invest:

1. Find a Custodian

Just like a traditional IRA, the first step towards having an SDIRA holding real estate is to find a custodian.

However, unlike traditional IRAs, you need to find a custodian that specifically allows you to purchase real estate in your SDIRA.

Though this is more difficult than finding a custodian for a traditional IRA, it is not an impossible task. Custodians including Provident, IRA Services Trust Company and IRA Financial Group provide such access. Some custodians have more involved fee structures than others, so it’s worth doing research and comparing options.

It bears mentioning that the custodian does not have a duty to perform due diligence on the assets you decide to purchase in an SDIRA. The duties of the custodian are limited to managing the transaction, doing the paperwork and reporting the finances.

According to the U.S. Securities and Exchange Commission, “Custodians for self-directed IRAs disclaim most duties to investors,” and this includes the duty of evaluating “the quality or legitimacy of any investment in the self-directed IRA or its promoters.”

2. Operate a Self-Directed IRA

Once you have your SDIRA account with a custodian, you can proceed in two ways.

First, you can choose to open an LLC corporation under the SDIRA through which you make all purchases and sales. Also known as checkbook IRA, this option allows you to have complete control over your SDIRA. The LLC will have a checking account, name and tax ID number through which you can make transactions.

The second option is to purchase and sell through a broker. In this case, the broker deals with your custodian to purchase properties with the money in your SDIRA and charges a fee for the service.

3. Buy Real Estate

The first thing to understand is that your SDIRA is a separate legal entity from yourself. When you buy properties, you are doing so in the name of your SDIRA. All purchases are made through money in your SDIRA and all rental income and proceeds from sales of properties are remitted into the same account. Similarly, all expenses on repairs and maintenance are made from the SDIRA account.

That you invest in real estate does not undermine the IRS-mandated contribution limits: You can’t contribute more than $7,000 (if you are under 50) or $8,000 (if you are age 50 or older) annually to any IRA. Consequently, every transaction on real estate has to take place within that contribution limit. Any contributions beyond that limit come with a hefty 6% tax penalty.

Since it’s almost impossible to get a mortgage to purchase properties through your SDIRA, you will likely have to make all purchases from your SDIRA with cash. This also means there is no tax deduction for mortgage interest payments. In the unlikely event that you do get approved for a mortgage through your SDIRA, income from properties bought with the mortgage will be considered as unrelated business taxable income and be taxed at the corporate tax rate.

Similarly, since the income you earn on your real estate grows tax-free in your SDIRA account, you won’t enjoy any deductions for property taxes.

4. Rent or Sell Real Estate

Any income you make from renting or selling real estate also goes back into your SDIRA account.

If your SDIRA is Roth, income will be taxed at the point of contribution, then grow tax-free until you withdraw it tax-free. But if it’s traditional, the income is not taxed at the point of contribution and will grow tax-free until taxed at the point of withdrawal.

For both traditional and Roth SDIRAs, you can’t make a withdrawal until you are 59 1/2 years old. However, for the former, you are also mandated to start making withdrawals (called required minimum distributions, or RMDs) by the time you turn 73 in most cases.

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What Rules Are There For Investing In Real Estate in an SDIRA?

Remember that IRAs exist to benefit you during retirement, not beforehand, and the investments held within an SDIRA are no different. If you’ve noticed, we have emphasized that there is a legal separation between you and your SDIRA. This separation is even more explicit by the various rules guiding an SDIRA.

Disqualified Persons

According to the IRS, the following are considered disqualified persons for the purpose of your SDIRA:

  • Yourself
  • Your spouse
  • Your parents, grandparents and great-grandparents
  • Your children, grandchildren, great-grandchildren and their spouses
  • The service providers of your SDIRA
  • Any entity that owns more than 50% of the property

None of these disqualified persons can use or otherwise immediately financially benefit from the property you purchase through your SDIRA, including as a vacation home, a second home or a business space.

Self-Dealing Transactions

Similarly, you cannot buy or sell properties to any of these disqualified persons. Such transactions are considered self-dealing, and they come with penalties (for one, you will lose the tax-free and tax-deferred benefits on that property).

What Are the Benefits of Investing in Real Estate?

Given the stress and difficulties associated with investing in real estate through an SDIRA, why do investors still go ahead with it?

Benefits Investors Seek To Enjoy From Real Estate SDIRAs

High Long-Term Returns
Since SDIRAs have long-term horizons, many investors believe that they are well suited for real estate investments which also have long-term horizons. Over the long term, investors hope that they can sell their properties for a high price and therefore earn high returns.

This is an especially strong point for those with experience in the industry or those with sufficient enough knowledge of a particular real estate market to make wise investments.

Hedging Against Inflation
Real estate has traditionally been viewed as a hedge against inflation. When the prices of goods and services increase, rent and the prices of homes often increase with them, providing security for investors.
Many investors consider real estate an opportunity to diversify their traditional investment portfolios of stocks and bonds. Data collected from Morning Star and analyzed by ETF Trends between 2012 and 2020 shows a near-zero correlation between real estate and bonds (0.04), bitcoin (0.01) and gold (0.09) while the correlation is stronger with stocks (0.73).

This means that real estate is a good diversification tool when coupled with bonds, bitcoin and gold, but not so much with stocks. Nevertheless, real estate remains a diversification tool for many investors.

Passive Income
The rental income from properties grows tax-free in an SDIRA. Real estate, therefore, presents an opportunity to earn regular passive income in the interim. However, remember that you can’t withdraw your income until you are 59 ½ years old.

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What Are the Drawbacks of Investing in Real Estate?

All is not simple and straightforward when purchasing real estate from your SDIRA. There exist some drawbacks that might constitute turn-offs for some investors.

Drawbacks to Purchasing Real Estate with an SDIRA

Finding a Custodian
Identifying custodians who allow real estate can be challenging. Since the pool is smaller, you might also have to pay high fees with little wriggle room to negotiate more favorable terms.
Lack of Tax Deductions
If you pay with cash, you won’t enjoy any mortgage interest payment deductions. There are also no property tax deductions or depreciation on the property.
Outsourced Property Management
As a disqualified person, you can’t handle the repairs and maintenance of your properties yourself. Again, there is a legal separation between you and your SDIRA. Therefore, all repairs and maintenance must be outsourced.
Contribution Limits
Owning and maintaining properties can be very expensive. This means there is a good chance you will need to exceed your contribution limits if you intend to keep your properties in good condition. This comes with a 6% tax penalty that you’ll have to factor into your overall costs.
For a traditional IRA, you must start making RMD at 73. However, real estate is illiquid and it takes time to convert a property to cash. If your RMD sets in and you can’t quickly turn real estate into cash, you will incur penalties.

Apart from RMD, you might also need to make a voluntary withdrawal out of need (provided you are 59 ½ years old or above). If you can’t turn your property into cash as quickly as you would like, financial stress may be unavoidable.

Higher Risk
With stocks and bonds, you can easily and predictably reduce your risk by diversifying. However, diversification is tougher with real estate because the price of one real estate parcel is significant compared to the price of one stock or one bond. This inability to diversify means you are taking on more risk — your eggs are concentrated in one or two baskets and any loss will be felt in a more significant way.

Investing in Real Estate Through Traditional Investment Vehicles

For those who would like to invest in real estate but are skeptical to do so through a real estate-focused SDIRA the drawbacks, there are other ways to invest in real estate through traditional investment vehicles.

First, you have real estate investment trusts (REITs). These are companies that pull money together to buy and sell properties. Since they have more investable dollars, they can diversify. Instead of buying and selling properties yourself, you can invest in the stocks of these companies and enjoy the benefit of diversification.

Second, you have real estate ETFs. These are exchange-traded funds that invest in a basket of REITs. Instead of buying one or two REITs here and then, you can buy a basket that contains tens or even hundreds of REITs. This way, you can enjoy even further diversification and reduce your risk exposure.

Third, are real estate mutual funds. They are similar to ETFs except that, while ETFs can be traded during trading hours, mutual funds are only traded at the end of trading hours.

With these three instruments, you can overcome the illiquidity, high costs and high-risk drawbacks of real estate SDIRAs. However, these other options might not provide the kind of long-term returns you might make otherwise.

But do you have the prowess to make those choices and live with the associated disadvantages? The choice is yours. However, ensure you speak to your financial advisor before making such an impactful decision.

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Frequently Asked Questions About Real Estate SDIRAs

Can I invest in real estate with other types of IRAs?

You can only invest in real estate with a self-directed IRA. Even so, not all custodians allow investing in real estate. Consequently, you have to find a custodian who offers self-directed IRAs that allow real estate investing.

How will my SDIRA custodian manage my real estate transaction?

The custodian is responsible for managing transactions, doing the paperwork and recordkeeping. Though they are not responsible for doing due diligence for the properties you want to buy, they do facilitate the transaction.

Do I own the real estate that I buy with my SDIRA?

You own the real estate through your SDIRA. Any rental income or profit on sale goes straight into the SDIRA account rather than your personal bank account.

Can I use the property I buy with my SDIRA as a home?

No, you may not use the property purchased within an SDIRA. You are a disqualified person as per IRS regulations; you cannot use the property as a home, second home, vacation home or business space.

Please seek the advice of a qualified professional before making financial decisions.
Last Modified: March 11, 2024
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