An individual retirement account (IRA) is a retirement account that allows you to save money for retirement with tax-free or tax-deferred growth. This is very similar to a 401K, but instead of your employer managing the account, you manage it yourself through a bank or broker.
While a few kinds of IRAs exist, the primary types are traditional and Roth IRAs. A traditional IRA lets you deduct contributions from taxable income, but you will later pay taxes on any interest or growth you earn upon making withdrawals. Conversely, Roth IRAs allow you to pay taxes upfront, so you don’t have to pay them later after accruing interest.
Why does this all matter? Self-directed IRAs let you take control of choosing how your account is invested. Typically, individuals use their IRAs to invest in financial assets such as stocks and bonds, but you can also use an IRA to buy rental properties.
Choose Your Self-Directed IRA
To begin, you have to choose a self-directed IRA (SDIRA). An SDIRA offers the IRA custodian—the person who holds your account—alternative investments for you to choose from, as SDIRAs are independent from banks and brokers. To invest in rental properties, you could have to open either a traditional or Roth IRA. Your IRA custodian will help make sure, for a fee, that you don’t accidentally violate any rules or restrictions regarding real estate transactions.
Choose Your Method of Funding
Investing in rental property through an IRA requires a decent amount of money, as you’ll need sufficient cash to pay for the mortgage, taxes, repairs, insurance, and other fees. You can get this money by transferring funds from one account to another of the same type, using rollover funds between accounts, or providing annual contributions. However, there are set limits on how much you can contribute annually.
You may be able to find a bank that will offer you a loan. With this method, you risk any revenue from the property falling under unrelated taxable income, and your money may lose value.
Know the Rules and Regulations
You must know that the property you invest in through an IRA is not your own. It belongs to the IRA. If you buy or use the property improperly, you risk voiding the IRA, in which the funds will become taxable. Therefore, you have to invest and manage the property in accordance with the International Revenue Service (IRS), and there are certain prohibited transactions you need to understand.
First, certain disqualified persons cannot use the rental property for personal use. Second, you cannot buy property from these disqualified persons or transfer assets to the benefit of a disqualified person. Lastly, a disqualified person cannot provide goods or services to the property. Disqualified persons are as follows:
- You, your spouse, or family members
- IRA service providers
- Anyone who owns 50 percent or more of the property
Find a Rental Property
Once everything is set in place and you’re equipped with the right knowledge, your next step is to select a rental property. To do so, you must make sure the contract lists your SDIRA as the buyer. Then, once accepted, your provider will give your deposit to the title company. However, your provider can only do this once they receive the Purchase Contract and Buy Direction Letter. After this, you can request money from your provider to cover inspection expenses by opening and closing an escrow.
To open an escrow, your provider will give you a set of necessary documents for you to fill out before you conduct your inspection and tie off any loose ends. Then, once you’re satisfied with the inspection processes, you resubmit the documents sent to you, and add they will add funds to your remaining balance if everything is in order. Once complete, your IRA owns the real estate, and you can then begin vetting tenants and managing your property.
Managing Your Rental Property
Remember—the IRA owns your rental property, so you must follow certain guidelines to manage your property without voiding your IRA. This means that you must pay any and all operating and repair expenses with IRA funds. If you repaint a wall or have a disqualified person do it for you, you risk the IRA funds becoming taxable.
Instead, you must use IRA funds to pay separate third parties, such as contractors and property managers, to handle these things for you. Additionally, all profits the rental property generates must remain within the SDIRA, but this does allow for continual tax-free growth for greater returns.
The Pros and Cons of Investing in Properties Through an IRA
Now that we know how to use an IRA to buy rental properties, the question then becomes if you should use an IRA to invest in the first place. In truth, just like anything else, this method comes with its own set of pros and cons, and it’s not for everybody.
For many investors, the biggest con of investing through an IRA is that you don’t receive tax benefits such as deferred capital gains. Plus, you can’t claim deductions for things like depreciation or mortgage interest. There are also a lot of rules you must abide by for your funds to remain untaxable, and while your custodian will help you, it’s still extra work.
However, long-term real estate investments tend to yield more returns, and an IRA is the perfect setting for a long-term investment. It also helps you avoid traditional assets like stocks and bonds, which is particularly helpful if you want to diversify your portfolio. Plus, you have the option of choosing the properties you want to invest in, providing you with a steady stream of tax-free growth from properties you can rely on.
While there are specific rules regarding IRA rental management, you can still use real estate managers to offload some of that work while complying with IRS rules. At Excalibur Homes, our property managers have years of knowledge and experience to help make investing and managing your rental property a breeze. With us, you don’t have to worry about hiring contractors, conducting background checks, collecting rent, or any of those time-consuming processes. You just get to sit back, relax, and watch your investment appreciate.
