As a good Financial Slacker, I have been diligently putting money into 401Ks for years. And when I changed jobs, I rolled those 401Ks into IRAs. After years of regular automatic contributions, I have accumulated a substantial amount in these pretax accounts.

Currently, these pre-tax accounts are primarily invested in mutual funds with a small allocation in bonds, alternatives, and cash. I am concerned about the extent of my exposure to the equity markets and would like to reduce my allocation while still generating decent returns. The problem is that investment options are somewhat limited for IRAs and 401Ks. As such, I am looking to use funds held in my IRA to buy real estate rental property.

As I think this through, a number of questions/concerns come to mind as outlined below:

1. Need to set up a self-directed IRA
2. Cannot commingle after-tax funds with pre-tax IRA funds
3. Will lose any tax benefits typically associated with real estate ownership
4. Difficulty getting a mortgage
5. Why not buy REITs instead?

 

Setting Up a Self-Directed IRA to Buy Real Estate

This may be the biggest roadblock of all and is a non-starter. In order to use an IRA to buy real estate, you need to move the funds into a self-directed IRA. A self-directed IRA differs from a self-managed IRA offered by traditional brokerages like Schwab, Fidelity, e-Trade. In the self-managed IRA, you select stocks, bonds, mutual funds, ETFs to buy and sell. It’s pretty hard to get in trouble unless you actually withdraw the money from the account. On the other hand, in a self-directed IRA, you hire a custodian to hold the funds. The custodian then makes purchases based on your direction. Unlike in a self-managed IRA, in a self-directed IRA, the responsibility falls on you for ensuring that the investments don’t violate any of the rules that might cause your IRA to lose its tax benefits.

And these rules are extensive and complicated. They range from self-dealing, to unrelated business taxable income, to the timing of mandatory withdrawals later in life.

There are companies that specialize in providing custodian services for self-directed IRAs, but this will require a significant amount of research in order to get comfortable going down this path.

 

Commingling After-Tax Funds with Pre-Tax IRA Funds

This is another big potential problem area. If you buy a property with IRA funds and later invest non-IRA funds (possibly for renovations or to cover the mortgage during a vacancy) you can easily jeopardize the tax status of the IRA thereby triggering a taxable distribution along with penalties and interest.

In order to avoid this scenario, I would need to ensure the IRA is adequately funded to remain solvent no matter what happens. Theoretically, you could bring in funds from a third-party partner if needed, but the partner couldn’t be a family member. If this situation were to occur, I would think your leverage with a potential partner would be pretty weak and you would wind up giving away a substantial portion of the value.

Again, once you exit the self-managed IRA world and enter the self-directed IRA world, the rules become your responsibility and you need to know what you’re doing.

 

Loss of Tax Benefits When Using an IRA

This is pretty easy to understand, but it could have a significant economic impact. Because the real estate is owned by the self-directed IRA, the tax benefits associated with depreciation, repairs, maintenance, mortgage interest, taxes, insurance, and other all now reside within the IRA and cannot benefit me the IRA owner.

 

Can You Get a Mortgage in a Self-Directed IRA?

I do believe you can get a mortgage in a self-directed IRA; however, it would need to be non-recourse meaning if you failed to repay the loan, the only recourse for the lender would be to foreclose on the property. Based on this, I would assume you would pay a rate premium and need to come up with a substantial down payment (if you could even get the loan).

Also, Unrelated Debt Financing Income tax (UDFI) will apply, which will subject the portion of the income or gains that are debt financed to Unrelated Business Taxable Income (UBTI). Honestly, I’m not even sure how to determine this.

 

Why Not Use REITs to Access Real Estate with Your IRA?

Another option would be to purchase REIT shares with the IRAs.

This would probably be simpler in that there are a number of REIT funds available and all of the above issues go away if I go the REIT route. But the two big disadvantages I see with REITs are (1) you lose the ability to use leverage in the form of mortgage debt to extend your purchasing power and (2) you lose any potential tax benefits of owning real estate directly.

As I go through this analysis, there are definitely some major concerns, costs, and risks associated with using an IRA to buy real estate.

I would love to hear feedback from people who have used their IRAs to buy real estate rental property. Alternatively, if you have considered this and rejected it, why? Would REITs be a better alternative?

 

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