An individual retirement account (IRA) is an account with tax advantages used for the purpose of saving and investing for retirement. There are several types of IRAs, all with specific rules regarding eligibility, withdrawals, and taxation.

What is a self-directed IRA?

A self-directed IRA is a type of individual retirement account with a wider range of investment options, particularly real estate investments. Not only does it offer advantages that can help an investor achieve their dreams for retirement, but it also pairs as a way to finance an investor’s real estate interests.

A self-directed IRA can be either a traditional IRA or Roth IRA in which there is a wide range of investments. It is an especially appealing option for people wanting to use a self-directed IRA to purchase rental properties.

What are the pros of a self-directed IRA in real estate investments?

Utilizing your self-directed IRA to invest in real estate offers an opportunity to make a more diverse and resilient portfolio, with advantages to take on different assets such as private equity, real estate, and precious metals. By diversifying your assets through investments in various real estate projects, it can also act as a buffer against market fluctuation.

Investing in real estate using a self-directed IRA comes with tax benefits. Similar to other IRAs, the income that goes into an IRA is not taxed until withdrawn. If using a Roth IRA, however, income taxes are paid as usual, but investment gains inside the IRA account will grow tax-free and can be withdrawn tax-free as well.

For the investor more interested in taking a more active role in their investments, owning local real estate in an IRA can allow them to put funds in assets that they already know and trust, offering a sense of familiarity and control. This may be particularly helpful through periods of economic uncertainty.

In addition to allowing you to be more active in your investment, a self-directed IRA also allows you to leverage your investing knowledge. Especially for the experienced investor in real estate, a self-directed IRA offers the ability to save for retirement utilizing personal experience and skills.

What are the cons of a self-directed IRA in real estate investments?

On the flip side of the point made above about investor involvement, a self-directed IRA requires investors to be responsible for keeping up with their properties and tenants. This could lead to problems, as an investor without prior experience may make risky decisions or manage poorly. And in case of fraud, they could be a bigger target than investors with more experience.

Liquidity may also be an issue for an investor holding real estate in an IRA. Cash can be difficult to access quickly if it’s tied up in real estate.

While IRAs offer the ability to defer taxes on investment income and have the potential for tax-free growth, there is also the possibility for taxable penalties should an investor go about their investments in the wrong way. In this case, it may be very important to work with a reliable custodian.

Should a property operate at a loss, real estate investments through an IRA do not have access to the same tax breaks that real estate investors might have outside an IRA. An investor cannot claim depreciation on real estate owned through an IRA. In addition, an IRA cannot be used for the purchase or selling of personal properties, including to immediate family members. Any IRA transactions should be impersonal as IRA tax breaks won’t apply to any personal transactions.

Getting started:

Your first step should be to do appropriate research on all the pertinent IRS rules. Next, you’ll need to set up an account. Individuals can establish either traditional or Roth IRAs, which should be opened through IRS-approved institutions. These institutions include brokerage companies, banks, savings and loans associations, as well as federally insured credit unions. If you already have an IRA, you can turn it into a self-directed IRA without difficulty or penalties, or if you have a dormant 401(k) account, those funds can also be easily transferred.

Since IRAs can be complex, it is useful to work with a custodian on your account to help you navigate the IRS tax code, as to avoid issues with the IRS in reporting your yearly investment values. Not all custodians are willing to take on real estate investments since they can be more complex than other types of IRA investments. Accordingly, some custodians may involve more fees, so it’s your responsibility to find the right type of custodian for your account.

In the meantime, you can begin looking into potential properties that will work within your account’s budget, make appropriate purchases, and when approved, begin building your retirement savings while investing in unique real estate projects that you care about.

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