Using Your IRA to Invest in Real Estate

Did you know that you can use your IRA to invest in real estate? In a traditional IRA, you invest in a fund comprised of stocks, bonds, and other common types of investments chosen by a plan administrator. With a self-directed IRA, investors have the freedom to pick the exact assets that they’d like to hold in their account. That can include REITs (real estate investment trusts), or even entire properties.

In order to add real estate to your self-directed IRA, you will need to work with an IRA custodian, which is a person or company who will manage your IRA. Not all custodians are created equal, and they will differ on the types of investments they can handle, so you may have to talk to a few of them to determine if they are experienced with REITs or using an IRA to purchase property.

REITs

REITs vary in size and nature but tend to be comprised of large commercial and residential properties. While REITs are often traded on the stock market, they don’t reflect ownership of a company like a stock does. When you invest in REITs, you’re purchasing pieces of buildings. This means they will be subject to the same booms, busts, and fluctuations of real estate, including the ability to hedge against inflation. In times of high inflation, when rents and property values increase, the value of REIT shares will also increase.

Buying property

When you buy a property using your IRA, the IRA is the buyer acting on the investor’s behalf. Purchasing real estate through an IRA usually means being a cash buyer, because securing financing to purchase property inside an IRA isn’t easy. Therefore, the buyer’s IRA balance will have to be high.

The IRA custodian completes the purchase by wiring the funds, including all closing costs, from the buyer’s account to escrow. The IRA now owns the property. The title to the property will read something to the effect of “John Doe Trust Company Custodian [for benefit of] (FBO) [Your Name] IRA.” Once you rent out your property, the lease agreement with the tenant is signed by the self-directed IRA custodian, and rental payments are made payable to the SDIRA account. Similarly, any operating expenses must be paid out of the IRA.

When you purchase real estate using an IRA, it’s important to know that you will have a lot less leeway to use the property than if you bought the property with cash or traditional financing. You can’t use it as a home office, vacation home, a second home, or a place for your children to live. The reason for this is that IRA’s have a firm “no self-dealing” rule, which prohibits you from using an IRA asset in any way that benefits you personally. That includes borrowing money from your IRA, selling property to it, or you or your family spending the night in your property. 

The no self-dealing rule also bars even minimal first-hand involvement with your property. For example, if your property needed a minor repair, you may be tempted to fix it yourself. Unfortunately, the IRS considers this “furnishing services” to the IRA, which is strictly prohibited. The penalties for this are pretty steep. The entire IRA would be considered distributed to you, and therefore taxable, plus you’ll owe a penalty. Of course, this also means that you’ll need enough capital in your IRA to cover any repairs or other expenses your property incurs. To avoid violating the “self-dealing” rule, always keep in mind that your IRA owns and operates the property. So if you need to have work done on your property, your IRA must pay someone else to do it.

When your property generates rental income, all of that income goes straight back into your IRA. Because you do not personally own the property, you can’t access any of the income. Of course, you will eventually get the money when you make withdrawals from your account at retirement.

The Bottom Line

If you do decide to buy property using your IRA, you will have the advantage of collecting rent from your tenants and letting it grow tax-free in your IRA. Having said that, purchasing property through an IRA is an especially risky prospect. If you encounter significant repair or maintenance costs, you might need to make additional contributions to your IRA, which could also subject you to penalties for contributions that exceed the annual contribution limits. If you decide this is for you, make sure that you have a self-directed IRA custodian who is experienced with real estate transactions.

Active vs. Passive Investing: Which is More Profitable?

There are as many ways to invest your money as there are ways to spend it. Having said that, most investment strategies can be classified in either two ways: active investing and passive investing. Each strategy has its advantages and disadvantages, but one has a stronger track record for return on investment. But first, let’s break down each one.

Active investing is typified by investing in fluctuating assets, such as stocks and bonds. Active investing requires active oversight, typically by a portfolio manager. With active investing, you’re trying to anticipate the way the markets will rise and fall in order to determine the best times to buy and sell. It’s up to the portfolio manager to be laser-focused on market changes in order to strategize transactions.

Passive investing is carried out over the long-term with more stable assets for a buy and hold approach. Index investing in a good example of a passive investing strategy, in which investors buy into a representative benchmark, such as the S&P 500 index, and hold onto it for the long term. This strategy removes the need to scrutinize the ups and downs of each investment. Passive investors need to resist the impulse to buy or sell depending on market fluctuations. It’s basically a long-term investment in corporate profits across multiple companies.

So how do these two strategies stack up against each other?

Passive Investing Pros

  • With passive investing, the fees tend to be lower, since no one is actively managing the investments.
  • There is a clarity and straightforwardness to investing in an index fund. You always know what funds are included.
  • You are unlikely to have a large capital gains tax as the gains are modest.

Passive Investing Cons

  • When you buy into an index fund, those funds are pre-set, so the investor has no ability to specify which stocks to invest in or divest from.
  • The immediate returns on passive investing are smaller than the potential dividends from active investing. With passive investing, slow and steady is the name of the game.

Active Investing Pros

  • With active investing, investors and their portfolio managers have the freedom to invest in whatever stocks they like.
  • Active investors can exit specific stocks when they are underperforming. 

Active Investing Cons

  • Active investing is more expensive. With active portfolios, managers can charge one percent or more, compared with 0.6 percent on average for passive investments.
  • Active investing is inherently uncertain and requires constant attention.

As with most investments, the real question is which strategy will be more profitable.  Surprisingly, multiple studies have concluded that passive investing is more profitable. Only a small percentage of actively managed funds do better than passive indexes. With active investing, there is a higher likelihood for volatility, so whatever quick gains you receive can just as easily be canceled out by a quick drop. While passive investing doesn’t offer the exhilaration of a fast windfall, it ultimately offers a higher return.