Ever wish you could invest in real estate tax-free through your retirement accounts?

You can.

And it’s not that hard, either. Last week, we shared Martha’s story of investing in a small multifamily rental property and then retiring to tour Europe on a houseboat with her husband. She owned that rental property under a self-directed IRA.

If last week was about her inspiring story and the specifics of her rental property investment, this week is all about the nuts and bolts of how to invest in real estate using a self-directed IRA.

We’ll use Martha’s self-directed IRA as a case study. Here’s to avoiding taxes, legally!


First, an Overview of Equities and Your IRA

Yes, I’m a real estate guy. I wholeheartedly believe in the power of real estate investments to create passive income. But that doesn’t mean I don’t invest in equities too.

Not long ago, we covered a study comparing the returns of rental properties, equities, and bonds over the last 145 years. Rental properties had the lowest risk and highest returns, but equities were a close second for returns.

Equities make a great retirement investment when you’re young, because over a long time horizon they tend to grow and compound nicely. But equities come with some significant drawbacks, especially as you get older.

First, they’re volatile. Familiar with the concept of sequence risk? It’s essentially the risk that the market will crash right after you retire, so you’re crippled by the crash but don’t get the advantages of the subsequent market rebound, because you’re no longer investing money in.

One of the ways to reduce sequence risk is to move money out of equities and into a more stable and predictable investment. Most people jump straight to bonds, but bonds have produced terrible returns in the 21st Century. Instead consider an alternative investment.

Like, say, rental properties!

Another drawback of equities as you get closer to retirement is that you have no control over their returns. Buy a stock, then read in the headlines about a CEO sex scandal? You know what happens next: instant stock crash.

Finally, equities are strong on growth but weak on passive income. Sure, some pay dividends, but mostly you’re looking at “safe withdrawal rates” and gradually selling off your portfolio. (Further reading: The 4% Rule in Today’s Market & How Rentals Change the Math.)

And retirement is all about ongoing passive income.


Diversifying into Real Estate in Your IRA

Martha and her husband decided to move the majority of their retirement accounts into a rental property.

“The 2008 crash was a wake-up call for us. Leaving our retirement savings in the stock market and hoping for the best was too risky. Somebody dreamed up derivatives and rode that train ‘til it crashed and brought down a huge portion of the economy with it. Our retirement plan took a hit like everyone else. And we were helpless fools in the whole debacle.”

We did mention lack of control being a drawback of equities, right?

“Now real estate was something tangible; something we understood much better than the financial markets. The returns are based on the local market driven demand for housing.”

Martha and her husband Terry decided it was time to diversify.


Easier Ways to Invest in Real Estate with a Self-Directed IRA

The easiest way to invest in real estate in an IRA is to buy publicly-traded REITs in your regular brokerage IRA. But they offer little in the way of diversification, since they tend to move in too much correlation with stock markets.

For better diversification, try investing in private REITs through crowdfunding platforms, within a self-directed IRA. You still need to open an SDIRA custodial account, but from there it’s simple to buy shares of private REITs such as Fundrise and Streitwise (I own shares in both, for full disclosure). Both allow non-accredited investors to participate.

You can also invest money through crowdfunded hard money loans. I personally like GroundFloor for this: you can invest as little as $10 in each loan. You get to pick and choose which loans you want to fund, based on risk grading, interest, and the property and borrower details. Most of these are short-term investments, under a year, so it doesn’t lock up your funds indefinitely.

Alternatively, you can invest in private notes in your SDIRA, or raw land, or commercial property, any other direct or indirect real estate investments. For that matter, you can also invest in precious metals, cryptocurrency, or other alternative assets.

Try Millennium Trust Company as a reputable custodian for your self-directed IRA, who’s familiar with real estate investments. They work closely with Fundrise as SDIRA partners.

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How to Invest in Rental Properties in an SDIRA

Investing in rental properties in your self-directed IRA involves some extra complications, compared to real estate crowdfunding investments. But real estate investors also get more control over direct property ownership and management.

Here’s how to buy real estate in a self-directed IRA.


Step 1: Find a Custodian

With a self-directed IRA, you need a custodian or trust company to administer it for you and comply with IRS rules.

“The first thing we did was find a trust company that would agree to handle it. The trust company ‘manages’ the IRAs for us. We set up IRAs with them; they then invested where we told them to invest.

“It’s important to understand the relationship with the trust company – they make their money by charging a percent of the value of the trust. And you need to be careful what you are signing up for! It’s a long-term relationship with that company and a serious financial commitment.”

I asked Martha about her tips for other real estate investors thinking about a self-directed IRA, and which trust company she used. “I guess the most valuable tip is to shop for a trust company before you start looking at properties or making investment decisions. The choice of a custodian is important and should not be part of the rush or timeline when buying a property.

“We are very happy with the service that our trust company gives us (Peak Trust Company). Their fees seem reasonable.”

With us so far? You sign up with a trust company, they create the self-directed IRA for you, then you rollover some or all of the money from your existing IRA, 401(k), or other tax-deferred retirement account to your new self-directed IRA.

If you’ve ever changed jobs and had to rollover your 401(k) funds from your previous employer to a new one, or to an IRA, you know how the process goes. It’s relatively easy; they give you a form to fill out and you transfer the funds.


Step 2: Setting Up a Company to Invest Through

Own your rentals under an LLC? It’s basically that simple.

“We set up an LLC for the purpose of owning and leasing real estate. My husband’s self-directed IRA owns a percentage of the LLC, and my self-directed IRA owns a percentage of the LLC.

“Setting up the LLC is pretty straightforward. We had a law firm help fine tune the language of the operating agreement.” It’s worth noting that many people form LLCs on their own, depending on their level of comfort.

You file Articles of Organization with your state’s business licensing administration. It’s not “rocket surgery,” as my ex-girlfriend used to say.

“Then we set up a bank account, got a tax ID number and we were in business! The trust company can then cut the checks to buy the property.”

To recap: you open an account with a trust company to create a self-directed IRA, and transfer money to it. Then you create an LLC to buy the rental property under, so that your self-directed IRA has something to invest in!


Step 3: Financing a Rental Property in a Self-Directed IRA

Martha and Terry Robinson did not finance the rental property they bought in their self-directed IRA; they paid cash.

But that doesn’t mean you can’t use financing to buy rental properties under your self-directed IRA.

Borrowing money to buy real estate in your self-directed IRA is nearly identical to borrowing otherwise. You secure a loan, either from a mortgage that does landlord loans or from a private lender (whether a company or individuals, such as friends or family).

But if you do finance your rental properties in a self-directed IRA, there are two important points you need to understand:

First, to finance investment properties bought under a self-directed IRA, the loan must be a “non-recourse” loan. That means the borrower is not personally liable for the debt: the lender can only go after the collateral – the rental property – in the event of a default.

Not every lender will agree to that. Definitely a question to ask lenders early in the process, if you’re considering buying real estate using a self-directed IRA!

The second point you need to know about financing real estate in a self-directed IRA is that the property’s revenue is only partially tax-sheltered. It gets complicated quickly, but the short version is that only the “non-financed portion” of the property gets the tax benefits.

To use a simple example, say you buy a rental property under your self-directed IRA for $100,000, and you finance half of the purchase ($50,000). The IRS only considers the half you paid cash for as the tax-free portion. So, half of your cash flow would be tax-free, and you would pay taxes normally on the other half.

Talk to your trust company about the details of how this exactly works from a year-to-year tax perspective. It’s above my pay grade.

Whether you borrow money or stick to your own cash in your self-directed IRA to buy the rental property, your LLC now owns the rental property. Congratulations!

(article continues below)

Landlord Loans: Terms Comparison Chart

What short-term loan options are available for buy and rehab?

What about long-term landlord loans?

We break down several real estate investor and landlord lenders on LTV, interest rates, closing costs, income requirements and more.

How Rental Cash Flow Works in a Self-Directed IRA

What happens to the cash flow from the rental property?

The short version: The tax-free rental income must stay in your SDIRA until you reach at least 59 ½, otherwise it counts as an early distribution and you must pay both taxes and penalties on it. 

I’ll let Martha explain in her own words, how their cash flow works in their LLC and self-directed IRA:

“The money flows like this: We’ve hired a property management company to manage the apartments, including leasing, maintenance, collecting rents, paying bills, etc. Once per month, the property management company collects the rents and deposits the net proceeds into the LLC bank account. We control that account.

“Then once per month, the LLC pays a dividend to Terry’s IRA and my IRA at the trust company.”

Cash flow from the investment property goes to the self-directed IRA. Since you control what the self-directed IRA invests in (hence the name), you could use it to pay down debt on the rental property (if you have any), or invest in anything else: equities, private notes, even more rental properties!

Now, if you’re a young person not yet retired, that would be the end of the discussion. But Martha and her husband Terry have now retired, and withdraw money to live on from their self-directed IRA.

“The trust company then turns around and sends us IRA disbursements once per month. The trust company does the tax withholding for the IRA disbursements and issues the 1099’s at the end of the year.”


Separation of Personal & LLC Funds

Strasbourg, France, where Martha and Terry have parked their houseboat for the last few months.

“One thing we are very cognizant of is that the LLC account, funds, cash flow, etc. must always be completely separate from anything else we are doing. Funds must never, ever, ever be used by us directly or co-mingled.”

The IRS doesn’t have a sense of humor about commingling tax-protected funds in a self-directed IRA with personal funds. They will rain fire and brimstone down upon thee if you do it.

“We manage our LLC and rental property for the benefit of our IRAs. Not for our personal benefit.”

It may seem like an odd distinction, but it’s one worth making.

“We grossed $108,000 last year, and after paying all the expenses of taxes, management, maintenance, utilities, etc. we netted $63,000.”

That money went into their LLC bank account, then to their self-directed IRA, then was disbursed back out to them as retirement funds to live on. Easy peasy.


Pros, Cons, Cautions

Should you invest in a rental property using a self-directed IRA?


First, it’s a bit more complicated than just setting up a standard IRA with your investment banker and throwing money into mutual funds. If the words “trust company” make your eyes cross, maybe you’re better off buying rental properties separately and keeping a traditional IRA for now.

Another issue is that it can be tough to find vendors who are comfortable working with a self-directed IRA. “One of the biggest challenges is that not many folks do this, so getting accountants, contractors, property managers, banks, etc. up to speed is sometimes a lengthy process.”

Then there’s the commingling issue. Granted, It’s not like the money is going to wander from your LLC bank account to your personal checking account on its own! But that doesn’t mean everyone has the discipline to keep the money separate.

If you struggle with budgeting and controlling your spending, it can be tempting to pull money from anywhere it seems available. That spells trouble for commingling funds.

For all that, a self-directed IRA is an incredibly flexible way to invest in real estate for retirement. You get the full tax benefits of an IRA, but the ability to invest in rental properties, private notes, or almost anything else you choose. Martha has been thrilled with it.

“We couldn’t be happier with how it’s performed. Even if the real estate market goes into another slump, we are not worried. We do not have to service a loan, we can just lower rents. Oh well.”


Have you ever considered using a self-directed IRA to invest in real estate? What’s held you back?



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