How to Use Your Self-Directed IRA to Invest in Real Estate

There are many people who want to use their nest eggs to invest – to create a larger nest egg or an ongoing stream of income… or both.  Unfortunately, with many retirement plans, you get penalized when you withdraw funds.  Not to mention that you reduce the principle amount and thus the amount you can accrue.However, there is a unique retirement account which gives you the benefit of tax deferred savings as well as the ability to use the money to invest in without incurring penalties.  This is known as a self-directed IRA (SDI).

What can you do with your SDI?

Although there are several different types of individual retirement accounts (IRA’s), they all operate in essentially the same way.  You, and perhaps your employer, contributes money into an account.  You can either do so after tax or before, and this will effect how taxes are paid when you begin withdrawing the money after retirement.

An IRA is, in essence, an account that can be used to invest.  You can simply let interest accrue from traditional banking accounts, use the funds to invest in stocks, privately held businesses and even real estate.  How you and your IRA custodian manage your fund determines its outcome, of course.

So the big question is: what kind of return do you want?

Traditional IRA returns

Many people take the “safe” route with their IRA’s.  They let interest accrue from CD’s and so on, or perhaps have their money put into low yield but relatively safe mutual funds.

There’s nothing wrong with this, and if you’re happy with three or four percent on your money, then over time, your IRA will grow into a tidy sum.

Kick it up a notch

One of the most awesome things that you can do with your self-directed IRA is that it’s perfectly legal to invest in real estate.  Real estate has many advantages from an investment standpoint, although there are some restrictions.

For example, you may not use your SDI to flip homes.  This would be considered a withdrawal and subject to penalties and taxation.  On the other hand, you may invest your IRA into income properties such as multi-family apartments, storage facilities or office buildings.

For example, you could use $100K of your IRA to purchase or be part of a syndicate to purchase a large apartment complex.  Your after tax returns may be as high as 15 to 20 percent, and you also accrue added tax benefits. This money could then be shunted back into the IRA, or a portion of it could be used as income now. There are many options to choose from, and it all depends on your tastes and how much risk you want to assume.

How to Use a Self Directed IRA to Invest in a Private Company

The Internal Revenue Service puts few restrictions on what assets you can own in an individual retirement arrangement. You can’t use your IRA to buy life insurance, collectibles, jewelry, alcoholic beverages or some forms of precious metals. But there’s nothing in the law that says you can’t buy an interest in a closely held corporation or limited liability company, and you can even own the entire enterprise within your IRA.

However, a number of special rules apply. Identify a custodian. This is a business that is separate from you that is willing to hold the assets you elect to buy in the name of your IRA. They are frequently referred to as “third party administrators” and sometimes as “trustees.” They must be specifically authorized by the IRS to act in this capacity. Not every financial services company or provider qualifies, and this is a specialized area of financial planning, so ensure you are working with someone experienced with self-directed retirement accounts. Open an account with the new custodian. Once you’ve opened the account, fund it with new contributions (up to $5,000, as of 2012), or execute a trustee-to-trustee “rollover” transfer, directing your old IRA to transfer assets to the new IRA with the new custodian.

Your custodian will be able to provide you with the required forms. Identify the business in which you want to invest. You can invest in any business, domestically or abroad, as long as it’s not owned or controlled by you, your spouse, any of your ascendants or descendants, their spouses, any entities they control or any fiduciary advising you on your IRA.

For example, your broker or lawyer cannot solicit you to buy shares in their own companies. You can buy a fractional interest in a corporation, LLC or partnership, or you can buy the whole thing. Direct your custodian, in writing, to purchase the interest. Specify the purchase price, the counterparty, the number of shares (if a corporation) or the percentage of interest (if an LLC or partnership). Verify that the transaction has been completed correctly.

How to Add Money on Your Self Directed IRA Account

Many investors use self-directed IRA accounts to invest their retirement money in investments that do not fit the usual IRA criteria, such as real estate or limited liability companies. When you find an investment that you wish to purchase for your self-directed account, you may need to add money to the account in order to complete the transaction. In addition, you can add to your self-directed account through regular contributions.

All money that you wish to add to your self-directed IRA must go through the trustee that you have selected for your account. The trustee must receive the money and account for the additional funds, analyzing whether the funds are a yearly contribution or a rolled-over contribution from another account. The trustee will issue a Form 1099-R at the end of the year, which will document all contributions to the account. At the time of publication, you can contribute a total of up to $5,500 to all of your IRA accounts, including your self-directed accounts. You can contribute an additional $1,000 per year if you are age 50 or older. If your earned income is lower than these amounts, you can only contribute up to the amount of your earned income.

If your self-directed IRA is a Roth account, this contribution may be restricted if your income exceeds certain amounts. With a traditional IRA, you may always contribute if you are under age 70 1/2, but your ability to deduct your contribution from your income taxes depends on your income. If you have other IRA accounts that you have been funding regularly, these accounts may have considerable balances and could provide a ready source for funding self-directed IRAs as well as specific investments you wish to purchase.

The trustee of your self-directed IRA can initiate a trustee-to-trustee transfer of funds from other IRA accounts to your self-directed account by completing paperwork and asking the other trustee to send a check. When the self-directed trustee receives these funds, he will invest it as you have instructed. A rollover from a 401(k) account works similar to a rollover from an IRA. Your self-directed trustee requests the funds from the trustee of your 401(k) account. When the self-directed trustee receives the money, he invests it the way that you have instructed. To roll over funds like this from a 401(k) account, you must not be working for the employer any longer.

How to Use Your Roth IRA or SEP-IRA for Real Estate Investment

Most people who open typical IRAs put their money in normal investment products such as mutual funds. With a self-directed IRA, however, there’s almost no limit to what you can invest in. This applies to traditional IRAs, Roth IRAs — where your deposits are taxed but withdrawals are usually tax-free — and SEP-IRAs. A SEP is an IRA funded by your employer as an employee benefit. If you’re a sole proprietor, you can set up your own SEP. Nothing in the law says that a regular Roth IRA or SEP-IRA can’t invest in real estate, but many IRA managers prefer not to. You need to find a brokerage or bank that will let you direct how the IRA is invested.

If your current Roth IRA or SEP-IRA manager doesn’t do real estate, you can roll over some of the money to another account with a new broker. Fees tend to be higher for self-directed accounts than with regular IRAs. First you have to build up enough money in your self-directed IRA to afford the investments you have in mind. Once you have the money, apply the same standards you would for a non-IRA investment. Do your research, crunch the numbers to figure out your potential returns and be wary of anyone who assures you this particular real estate deal is a sure thing. One of the drawbacks to self-directed IRAs is that investment fraud is widespread.

One of the limits the IRS sets on your self-directed IRA — whether Roth, SEP or traditional — is that you and your account must keep at arms’ length from one another. If, say, your IRA buys a beachfront cottage and you then pay the IRA rent to stay there, that’s what the IRS calls self-dealing. If you’re caught doing this, the IRS will declare that everything in your IRA is now taxable income. That’s going to leave you with a nasty tax bite. One of the advantages of investing with an IRA is that you can buy and sell real estate without worrying about tax.

Nothing in your account is taxable; taxes come when you withdraw money in retirement, and with a Roth you don’t even pay tax then. The flip side is that you can’t write off any real estate losses. To deduct Roth losses, for instance, you have to empty out the account. If the account’s total value is less than you originally contributed, you can take that loss as a write-off.

How Do I Use a Self-Directed IRA to Purchase a Tax Lien?

With the uncertainty of the usual Individual Retirement Account investments, such as stocks, bonds or mutual funds, you may want to choose alternative investments for your retirement accounts. Tax liens are one type of investment that can be owned inside of an IRA. To make these unconventional investments, you must open a self-directed IRA account, and fund that account, using a self-directed IRA trustee. A self-directed IRA requires a special trustee who handles nontraditional IRA investments. An IRA trustee usually handles mutual funds, bank accounts and individual stocks, but often only serves as a trustee for the types of investments he sells. A self-directed trustee will hold other types of investments in your IRA account, such as real estate, privately held business and tax liens.

Ask a trusted financial adviser for a recommendation on a self-directed IRA trustee. Check the references of any candidate you consider, and make sure the trustee handles tax-lien investments. You will need to fund your self-directed IRA and establish an account to purchase tax liens. While you can fund your IRA with an annual contribution of up to $5,500, or $6,500 if you are age 50 or older, you will probably need more money to fund the investments you wish to make. Your self-directed trustee can handle the paperwork to transfer funds from any other IRA accounts you own.

A transfer from a 401(k) with a previous employer is also a possibility. A trustee-to-trustee transfer done this way has no tax implications and preserves the tax-advantaged status of your invested money. Different communities offer tax liens for sale using various methods. Some offer tax liens through traditional auctions, while others offer online auctions only.

While auctions sell liens to the highest bidder, some auctions sell the liens to the person bidding the highest dollar amount for the lien, and others sell the lien to the person who will accept the lowest interest rate, while paying the full dollar amount for the lien. Your self-directed IRA trustee will need to make any purchase of tax liens that you bid on and win at auction. This will preserve the tax-advantaged status of your IRA. You cannot handle the funds yourself for the purchase. The trustee will also hold the ownership of the liens in the name of your IRA account, and will collect the interest and payments to hold in the account as well. If the lien matures, and you end up owning the property, the self-directed trustee will also take ownership of the property for your IRA.

How to Set Up a Self-Directed IRA

The Securities and Exchange Commission defines a self-directed IRA as “an IRA held by a trustee or custodian that permits investment in a broader set of assets than is permitted by most IRA custodians.” Self-directed IRAs allow individuals and small companies to invest in asset classes that are often deemed illiquid. These include tax lien certificates, real estate, and private companies. Hence, self-directed IRAs allow people who prefer to leverage their personal expertise in their investments to do so. The choices of investments are simply expanded in these types of IRAs.

Confirm that a self-directed IRA can invest in your preferred asset class. Although a self-directed IRA allows you to invest in numerous illiquid assets, investments in some assets are prohibited. Collectibles, including artwork, stamps and rugs, are a prohibited asset class. In addition, you cannot use an IRA to invest in real estate that you will personally use. Select your financial institution. Banks, insurance companies, mutual companies and brokerage firms comprise the majority of IRA custodians and trustees. These firms generally invest only in the marketable securities they offer or sell.

These include stocks, bonds, CDs, annuities, and mutual funds. You probably will need to do some research to find an approved institution that allows you to invest in the assets you prefer. Complete the application in its entirety. As with other IRA accounts, you will need to provide your Social Security number and an approved form of photo identification. You must complete and sign the IRA agreements and disclosures. Pay any application fees. The asset classes self-directed IRAs allow often require individualized attention to ensure compliance with IRS rules and regulations.

Therefore, self-directed IRAs generally incur higher administrative costs because of this increased level of administrative oversight and paperwork required. Financial institutions typically pass on these costs to the IRA account holder. Fund your self-directed IRA account. You can make a one-time contribution or set up an automatic investment plan. You can transfer money directly from another IRA or an employer’s qualified pension plan. Alternatively, you can roll over the money. In the latter case, make sure you deposit the money within the 60-day time frame required by federal rules or else you will incur a penalty and taxes.


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