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If you opt to use a self-directed IRA to purchase real estate, be sure you understand the rules


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Q: I’ve enjoyed your columns for some time. What is your opinion of self-directed IRAs for the purpose of buying real estate within the vehicle? My son is a tax lawyer, and both he and my CPA think it is fraught with potential tax liabilities if it isn’t done right and most don’t have the right tax advice throughout.

I run a real estate brokerage company, and I own real estate outright as an investment vehicle and don’t need to use my IRA money to purchase more properties. But the agents who work for me are being told this is the way to go. Most agents can hardly fill out a contract right, so this whole idea of a complex vehicle is frightening to me and I want to prevent my agents from making a mistake that will cost them dearly.

I want your opinion as well as some guidance I can share around the office. Thank you.

A: Thanks for reaching out. I think the IRS has pretty well settled on the idea that if you use a self-directed IRA (individual retirement account), you can purchase real estate investment properties through them. But you can’t live in them, and all of the cash for and from the properties has to flow through your IRA.

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That’s a key part of the deal, and your son is right that if not handled correctly, it’ll be nightmarish. Self-directed IRAs for real estate investments are not for the fainthearted, that’s for sure, but as you already know, neither is real estate investment.

When IRAs were originally created, funds invested in IRAs generally flowed through mutual fund companies or investment brokerage firms. You put money in and then directed how those funds are invested. The account then invested in individual, publicly-traded stocks or mutual funds of your choice.

The key thing with an IRA investment is that you’re not actively involved with it. When you start to have a role in the financial arrangement or can benefit personally from the business side — as opposed to the investment side — you could run afoul of IRS rules relating to IRAs.

At some point about 20 or so years ago, some companies set up ways to use IRAs to invest in real estate. Now if that investment was in a fund of real estate managed by others, like a real estate investment trust (REIT), you had the same situation as a mutual fund in that you put money in, and that money was pooled with other funds to buy and invest in real estate. The key to the self-directed IRA for real estate was for the individual investor to buy specific pieces of real estate, manage that real estate and then sell that real estate, all within the IRA.

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If you do that, the “owner” of the real estate is the IRA. It stands to reason that the IRA would receive rents, the IRA would pay the expenses of the property, and the IRA investor wouldn’t receive any money directly from the property. That wouldn’t fly for many investors, as they need money to care for the property and need money from banks to buy the properties. So when you see an investor using IRA funds, the question is whether there is sufficient difference between the investor as an individual and the IRA as the owner.

If the water gets too murky, the IRS might invalidate the arrangement and the IRA investor could get socked with penalties and taxed for all the money that was invested in the IRA. We’re sure there are investors who have been quite successful in using IRAs to invest in their real estate deals, but those investors need to know the ins and outs of IRA rules. The investors also need to work with a company that can set up the IRA in the right way, knows what the investor can and can’t do, and makes sure that the wall between the investment and the individual are clearly drawn within the IRS guidelines. (Be aware that there are additional fees for using your self-directed IRA to run your real estate investments, and those extra fees and costs can add up.)

For many investors, those IRS rules could sometimes cause headaches. If you commingle personal funds into the building or use funds from the building to pay yourself as the owner or even manager of the property, you could destroy the whole arrangement (if you don’t know what you are doing). Investing in real estate is hard enough, but investing in real estate while having a whole new layer of rules and regulations that can trip you up at any time may be too much for most real estate investors.

[More Matters: A tax-deferred exchange can help you avoid the IRS when selling property at a profit]

For these reasons, we’ve never advocated that real estate investors use their IRA funds in a self-directed way. We know we’ll hear from people who will claim that self-directed IRAs are the best thing since sliced bread, and we’re happy to share stories on the plus and negative side, but we see some significant pitfalls for novice investors.

Ilyce Glink is the creator of an 18-part webinar and e-book series called “The Intentional Investor: How to Be Wildly Successful in Real Estate,” as well as the author of many books on real estate. She also hosts the “Real Estate Minute” on her YouTube channel. Samuel J. Tamkin is a Chicago-based real estate attorney. Contact them at ThinkGlink.com.


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