Self-Directed IRA for Real Estate: How Does it Work?

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Disclaimer: The following article is meant for educational purposes only and should not be taken as professional tax or legal advice.

If you want to use your retirement funds for real estate investing, one option is to set up a self-directed IRA. By combining the traditionally stable returns of real estate with a tax-advantaged savings account, you can legally use this strategy to turn significant profits.

But beware: These complex accounts are subject to strict IRS rules and regulations, including using a custodian or setting up an LLC as well as avoiding prohibited transactions.

In this article we’ll help you understand how to use a self-directed IRA to buy real estate.


What is a self-directed IRA?

Self-directed IRAs (SDIRAs) allow investors to diversify their holdings and take the direction of their retirement funds into their own hands.

While typical IRAs are made up of more traditional bonds, stocks, or mutual funds, a self-directed IRA can hold real estate, gold, or even invest in start-up, privately held companies, cryptocurrency, or livestock. In fact, the IRS Rules governing SDIRA accounts don’t create a list of eligible investments so much as they outlaw specific prohibited asset types instead. If you can locate a qualified custodian (also known as a trustee) for the deal, it’s likely you can make it happen.

But here’s where the “self-directed” part comes into play: The investment company managing a regular IRA is out of the equation. As the investor/account holder, the direction and performance of any deal is on you. While the custodian will help with IRS compliance, you must evaluate the prospects of any investment and make your own decision.


Real estate transactions

You may use your self-directed IRA to buy property or do it in partnership with another person, company, or another IRA. It can also be used to secure a loan for a property.

All funds used in the purchase and for costs associated with the property, such as maintenance, must come straight from your self-directed IRA. Likewise, all profits from a sale or rental income must flow into the SDIRA and not your personal account. After the sale of a property, the profits in the SDIRA may be used as capital for a new real estate deal.


Self-directed Roth or Traditional IRA

Your self-directed IRA can be a Roth (tax-free distributions) or traditional (tax-deductible contributions) setup. In either case, your account would be subject to the same IRS contribution limits as non-self-directed accounts. In 2020 these limits are $6,000/year or, if you are over the age of 50, $7,000/year. Your household income or other factors can lower these contribution limits.


IRS compliance

To be compliant with IRS rules for self-directed IRAs, you’ll need to hire a real estate custodian or set up an LLC to separate your personal funds from the retirement account. And you’ll want to avoid IRS-prohibited transactions.

A real estate IRA custodian can help you open your account. Once the account is open, on your behalf the custodian takes custody of the assets, holds any records, issues client statements, processes any transactions, and files any reports needed by the IRS.

Only assisting with compliance, the custodian is forbidden from advising you on any deal or purchase.

Unless you have extensive knowledge and experience with real estate investing, hiring a custodian is in your best interest.

Checkbook control
In this method you separate your retirement account from your other assets by establishing a limited liability company (LLC), owned by the self-directed IRA. By opening a bank account in the LLC’s name, you can write checks through the company for purchases and building maintenance. This is where the name “checkbook control” comes from.

Since this option removes the custodian from processing all transactions, which can slow things down, it may be an ideal structure for performing fast-paced house flipping or buying rental properties. However, since the custodian will no longer be assisting with compliance, this option is usually a better fit for experienced active real estate investors.

Prohibited transactions
The IRS outlines strict and complex rules and regulations for self-directed IRAs. If you violate any of them, it will disqualify your account, and all funds will be considered immediately taxable. 

In general, the rules are designed to stop you from double-dipping: using your retirement account in sneaky ways that have added benefits. With an SDIRA for real estate, you’ll need to avoid deals that benefit disqualified persons, engaging in self-dealing, or making hands-on improvements.

Disqualified persons
Disqualified people, such as your business partners, family, and friends can’t benefit from your investment in any way.

For example, if you used your self-directed IRA to purchase a vacation home, you couldn’t let your parents stay the night.

You can’t use what your self-directed IRA purchases for any additional benefit. For example, you can’t buy a property and then take out an equity line of credit on that property to pay off your credit cards.

Hands-on improvements
You can make maintenance decisions or make improvements on a property but can’t perform any work yourself.

For example, a plumber buys a house with his self-directed IRA. A plumbing leak is discovered in the property. The plumber decides to save money by getting out his tools and repairing the leak himself instead of calling a vendor. This breaks the IRS rules since he has “furnished services” to the IRA.


Real estate retirement savings, strict and complex rules

A self-directed IRA enables you to use your retirement account for real estate investing, diversify outside of stocks and bonds, and take more personal responsibility for your financial future.

However, SDIRAs must comply with a complex set of IRS rules. They are generally the territory of highly savvy and experienced real estate investors well-equipped to take matters into their own hands.

In a future article, we’ll outline the pros and cons of self-directed IRAs to help you decide if this pathway to real estate investing is right for you.

At Birchstone Investments, we help investors create passive income streams and grow long-term wealth through strategic multifamily real estate investments. If you’re interested in learning more about commercial real estate investment, join our investor community today.

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Jerry Hollifield

Jerry Hollifield

Jerry is the Managing Principal & Chief Investment Officer at Birchstone Investments, LLC. With a business career that spans more than 30 years, he has been involved in the acquisition, development, financing and management of over $400 million in real estate. In addition, he has been involved in more than 40 Merger and Acquisition transactions with total value exceeding $600 million.

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