Although most investors do not even know about self-directed IRAs, those who do know and understand these accounts can truly make a difference in how their retirement funds are put to work – and ultimately in how that money performs over time.
Investing in real estate can provide you with ample benefit. But, doing so within a self-directed IRA account can truly help you to explode your returns, because along with all of the other advantages to owning investment property, you are also able to obtain the tax-related benefits that IRA investing allows you.
In addition, a self-directed IRA account may also be able to provide you with even more benefits through use of a strategy that is known as “checkbook control,” as well as the ability to invest via an LLC (Limited Liability Company).
The good news is that, there are many financial institutions that specialize in these types of IRA accounts, and that can help you to ensure that your self-directed IRA is properly set up, funded, and ready to provide you with all of the benefit that these accounts can offer.
There are numerous benefits to owning a truly self-directed IRA account. These accounts can allow you many more choices in terms of investment vehicles, as well as tax-related perks. So, if you are seeking both tax advantages, as well as diversity in your retirement investing, then this could be a viable option.
- Control – When you own a truly self-directed IRA, you have much more control over what goes into your account. For example, rather than being “sold” only what your stock broker or banker happens to have on the “shelf,” you are the one who is controlling the investment vehicles that are purchased and sold. This can include tangible assets like residential or commercial real estate.
- Speed – Great investment opportunities don’t necessarily always come along at the ideal time. This is particularly the case with real estate, which will often require that you secure a loan before you can move forward with the purchase – or even with making an offer on the property. By opening up the door to money that was initially thought to be “locked up” in a retirement account, you can jump on deals much more quickly, knowing that you have the funds already available to back it up.
- Additional Growth Potential – A truly self-directed IRA can also give you the potential for added growth in your account. For instance, with regard to real estate investments, you can increase your return in two primary ways. First, the property itself can appreciate (tax-deferred or tax-free) over time.
In addition to that, your account will also be accumulating rental income throughout the time it is owned in your IRA. So, not only is the account accumulating rental income, but if the property sells for more than what you bought it for, the gains that are realized are not immediately taxed (or ever, if in a Roth IRA). This, then can provide you with the opportunity for exponential gains – those from the property’s appreciation, as well as the gain on the money that would have been taxed if you owned the property outside of an IRA account.
- Management – Because you have more control over what you’re investing in, you will also be in a better position to manage your portfolio. For example, no longer are you at the mercy of the stock market or mutual fund managers for the performance of your investments. Rather, you can use your specific knowledge and expertise to manage what you own yourself.
As an example, if you own rental real estate in your IRA portfolio, you can actually manage the property(ies) yourself by increasing the value through renovation, screening potential tenants, and collecting the rent money (which, by the way, goes into the IRA account and is able to grow tax-deferred or tax-free).
- Diversification – In addition to “traditional” financial vehicles like stocks, bonds, and mutual funds – which can be held within a regular traditional or Roth IRA account – a self-directed IRA is allowed to hold a multitude of both tangible and intangible assets.
And, because you’re investing in a tax-advantaged account, you’ll not only be able to reap the benefits of potential growth (and in some cases, income), but you can do so in either a tax-deferred or tax-free manner.
Just some of the assets that can be held in a truly self-directed IRA include
- Residential and Commercial Real Estate
- Raw Land
- Mortgages and Deeds (this includes first and second mortgages)
- Private Notes / Loans
- Commercial Paper
- Gold and Other Precious Metals
- Private Placements
- Limited Partnerships
- Tax Advantages – Because you are investing through an Individual Retirement Account, you will still be able to reap the tax-related benefits that are associated with IRA investing. These can include:
- Fully or partially deductible contributions (with a traditional IRA account)
- Tax-deferred (traditional) or tax-free (Roth) growth on the money that is within the IRA account
- Tax-free withdrawals (Roth)
- No required minimum withdrawals at age 70 1/2 (Roth)
- Assets can pass to beneficiaries after death in a tax-advantaged manner – which makes self-directed IRA investing not just beneficial for the investor, but also for future generations.
- Asset Protection – In addition to the growth and tax-related benefits of self-directed IRA investing, there is another key benefit. That is asset protection. Generally, IRA accounts are protected under the federal bankruptcy law, and therefore can be shielded from creditors.
Plus, if your self-directed IRA purchases property (or other assets) through an IRA LLC, even if you are personally sued, your IRA LLC assets can be protected, in turn, keeping your retirement assets safe for the future.
By taking advantage of potentially higher returns, along with the tax benefits of Individual Retirement Accounts, you can enhance your investment returns exponentially – providing yourself with a much larger asset base through which to generate retirement income in the future.
So how exactly can you end up netting more from your real estate investing by using a self-directed IRA?
First, after completing a successful real estate transaction, most investors will be required to hand over a sizable sum to the IRS in the form of taxes on the gain. When you invest in property through your self-directed IRA, though, you won’t have to split your profits with Uncle Sam.
This is because, just as with any other type of investment vehicle that you put inside of an IRA account, the tax that is due on the gains can either be postponed (with a traditional IRA), or eliminated altogether (with a Roth IRA
Because of this, the money that you are able to keep control of can again be used to put towards other investments – which in turn, can produce additional gains over time. This, then, has the effect of snowballing your returns throughout the years.
The power of compound interest is extremely compelling. One reason for this is because the compounding of interest can work both ways – in other words, it can work for you, or it can work against you.
Let’s take a look at an example. Bob is a real estate investor. He purchases a property for $100,000 to use as a rental. Over the next ten years, Bob receives regular monthly rent from that property – which he has to claim as income on his tax return each year.
On top of that, Bob did not have $100,000 in cash available to purchase the property outright. So, he uses $20,000 from his savings account as a down payment, and he borrows the other $80,000 at an interest rate of 5%.
Therefore, even though Bob can claim the interest he pays on his mortgage on his annual tax return, he also must make a mortgage payment to a lender every month – which consists primarily of interest rather than principal.
After ten years, Bob sells the property for $200,000 – and he subsequently is required to pay a tax on his $100,000 gain (the difference between his original purchase price of $100,000 and the price of $200,000 that he sells the property for).
Jim, another real estate investor, also purchases a property for $100,000. However, Jim buys the property within his self-directed IRA account. Because Jim has $100,000 in his IRA, he is easily able to fund the property, without the need to go through a bank or lender.
The rental income that Jim receives from his tenant goes directly into his self-directed IRA account. So, this money can also grow tax-deferred. When Jim sells his property ten years later for $200,000, he is not required to pay any gains tax on the $100,000 profit that he earned – which in turn, gives him all of his sale proceeds to purchase another property, or any other investment that he chooses, and continue compounding his returns.
You can also see higher net returns if you use your self-directed IRA to “flip” properties. For example, Bill is a real estate investor who comes across a two-bedroom home in need of some rehab work that is he able to purchase for $25,000.
Because Bill felt that the property would be a good deal for his retirement account, he instructs his self-directed IRA custodian to purchase the property on behalf of his IRA. The property needed improvement, so Bill also instructs his self-directed IRA custodian to submit $10,000 to a contractor who completes the needed fix-up.
Once the renovations are complete, Bill is able to turn around and sell the home for $100,000 – which nets him a profit of $65,000. This profit remained in Bill’s self-directed IRA account, ready to be invested into the next deal that he finds.
Had Bill have done this exact same deal outside of his self-directed IRA account, he would have had to pay 28% in taxes. But, because his tax is deferred, the difference for Bill in just this one single deal was $18,200. (28% of Bill’s $65,000 profit equals $18,200 that would have otherwise gone to Uncle Sam in taxes).
While there are a myriad of benefits to investing within a self-directed IRA, there are also a few factors that you need to consider before moving forward with opening and funding an account so that you stay within the proper parameters.
First, if you use your self-directed IRA to purchase real property or other tangible assets in your account, know that you are not able to sell these assets as quickly as you would stocks or mutual funds. Therefore, illiquid assets such as real estate should typically be considered as more of a long term endeavor.
Also, investing in a truly self-directed IRA account does require that certain rules are followed – and if they are not, you run the risk of losing the tax-related advantages that can make these types of accounts so beneficial. In some cases, you could also be liable for penalties and / or fines, or even the closure of your account altogether. So, it is important that you follow the IRS’s plan asset rules.
These include not investing in financial vehicles that aren’t allowed to be in a self-directed IRA account, as well as veering away from prohibited transactions such as “self dealing”. For example, even though there is a long list of assets that are allowed to be held in a self-directed IRA account, some options – such as life insurance and collectibles – could end up jeopardizing the tax-deferred or tax-free status of the account.
You also are not allowed to use the funds in your self-directed IRA account, either directly or indirectly, to benefit yourself or a person (or entity) that is considered to be a disqualified person. For instance, you are not allowed to use your IRA to purchase a home for you to live in – or even a vacation home to use yourself (or for any other disqualified person to personally use).
Likewise, you are not allowed to pay yourself any type of fee or compensation from the money that flows into the self-directed IRA account, such as from the rental income of your investment property(ies).
A self-directed IRA owner is also not allowed to “self deal,” meaning that the transactions that take place in the account must be done at arm’s length and not involve the IRA account owner, or even members of his or her family.
The IRS penalties for not following the rules can be fairly harsh. As an example, if you have $1 million in your self-directed IRA, and you use $200,000 of it to purchase a property that you use as a vacation home for yourself and your family members, the IRS could actually consider that the whole $1 million in the account has been “distributed” and in turn, make the entire account balance subject to income tax. And, if you are under the age of 59 1/2, the IRS could also charge you an additional 10% early withdrawal penalty.
A “disqualified person” as it relates to self-directed IRA accounts, would include you (the IRA account owner), as well as:
- Your spouse
- Your ancestors and lineal descendents (such as your children and grandchildren)
- Your ascendants (such as your parents and grandparents, as well as your spouse’s parents and grandparents)
- Spouses of your lineal descendants
- Any investment manager and / or advisors for the self-directed IRA account
- Anyone providing services to the IRA, such as the trustee or custodian
- Any corporation, partnership, trust, and / or estate in which you own a 50 % or greater interest
With that in mind, be sure that you are familiar with the IRS codes that pertain to self-directed IRAs, as you don’t want to bring about negative tax consequences such as the tax-deferred or tax-free status of the account, or even the disqualification of your IRA account altogether.
Provided that your self-directed IRA account is properly set up and funded, and that you follow the IRS rules that are related to such accounts, you have the opportunity to reap some tremendous returns, along with tax-advantaged gains, that can ultimately make a big difference in your future retirement lifestyle.
Self-directed IRA accounts have very specific rules regarding who can and cannot have personal use of the assets, such as real estate, that are purchased through the account. List those who are considered to be “disqualified persons” as it relates to a self-directed IRA.
Your ancestors and lineal descendents (such as your children and grandchildren)
Your ascendants (such as your parents and grandparents, as well as your spouse’s parents and grandparents)
Spouses of your lineal descendants
Any investment manager and / or advisors for the self-directed IRA account
Anyone providing services to the IRA, such as the trustee or custodian
Any corporation, partnership, trust, and / or estate in which you own a 50% or greater interest