Should I Invest in Real Estate Inside a Self-Directed IRA?

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If you’ve done a great job contributing to your IRA, you may get tempted to invest in real estate inside of that IRA.

But is investing in real estate inside an IRA as fun and exciting as it sounds? That’s what a listener of the Clark Howard Podcast recently asked.

Should I Invest in Real Estate in a Self-Directed IRA?

Should I invest in real estate inside my IRA?

That’s what a Clark listener wanted to know on the May 22 podcast episode.

Asked Todd in Texas: “My wife and I are 39 years old. We have three sons (14, 11 and 9) and are debt-free except for our home. We max out our IRAs and my 401(k) every year.

“We have $198,000 in our traditional IRAs and $460,000 in Roth IRAs. We want to get into real estate for retirement and have heard about using a self-directed IRA to buy real estate. We’d like to do this with the cash we have in the IRAs rather than getting a mortgage if possible.

“What does Clark think of this approach? Should we use the money from our Roth or traditional IRAs?”

Clark congratulated the couple for saving so much toward retirement in their 30s despite having three children. Most people use young children as a financial excuse to avoid saving for retirement, he says.

As far as the idea of investing in real estate inside an IRA? Stay away. Far away.

“I know there are pitches everywhere telling you that this is nirvana to own real estate through an IRA,” Clark says. “And I think it stinks. Don’t do it that way.

“I hate these self-directed IRAs. I can’t stand them. They have very, very high costs. And they’re an area that’s been abused by a lot of people. So you’re more subject to oversight from the IRS.”

4 Reasons To Avoid Self-Directed IRAs for Real Estate

Here are some of the reasons why investing in real estate inside of an IRA may be a bad idea.

1. You Must Set Up Your Self-Directed IRA Correctly

As Clark mentioned, it’s easy to step afoul of all the specialized IRS rules regarding real estate investments inside an IRA.

Specialized companies act as custodians for self-directed IRAs.

Any mistake you make when setting up such a purchase can bite you later in the form of surprise tax liabilities and penalties. So you may even want to hire a real estate attorney to make sure you avoid setup mistakes.


2. Potentially Heavy Penalties

If you do make a misstep, which is easy to do, the IRS can go as far as disqualifying your self-directed IRA.

That means that every fund, transaction and cent of profit becomes taxable.

An example of an easy rule break: You invest in real estate within your self-directed IRA. Then you let your son move into that house.

It doesn’t matter whether your son and his family are paying rent, as that’s considered “self-dealing.” If the IRS finds out, it can make every dollar you spent on the house subject to taxes and penalties.

You also must pay for all repairs, taxes, insurance, utility bills and fees — the hidden costs associated with home ownership — from money that’s inside your self-directed IRA.

Also, making a simple repair to the home yourself, or even furnishing the house with furniture you own, is against the rules.

3. You Lose Your Real Estate Tax Benefits

The government encourages you to invest in real estate outside of a retirement account by handing you several tax advantages. For example, you can write off depreciation and the interest you pay on a mortgage loan on your taxes.

You lose all of those tax benefits when you invest in real estate inside of an IRA.

“Real estate has its own embedded tremendous tax benefits having it as a regular, taxable investment. So there are clear benefits without all the crazy rules and overhead costs of doing this with IRA money,” Clark says.

“I’d rather you build up enough money so you can make a down payment on investment property and you own it as a personal investment rather than inside an IRA.”


4. The Opposite of Diversification

Clark’s favorite retirement account investment recommendation is a target date fund. He’s a big fan of spreading your investment money across the entire U.S. business market rather than making “bets” on individual companies (stocks).

Well, putting hundreds of thousands of dollars into a single real estate property isn’t much different. You now have an outsized position tied to that property.

Plus, it’s going to be difficult to wind down that investment when you’re in retirement. You can sell fractional shares of a stock. But you’ll need to sell the house to cash out any of your investment.

Real Estate Inside an IRA: Traditional or Roth?

Let’s say that despite Clark’s warnings, you’re going to invest in real estate inside of a self-directed IRA. Should you do it within a Roth or traditional IRA?

“A Roth IRA already has the benefit of being tax-free money. Tax-free growth. Tax-free spending. You lose the tax advantage of owning real estate as an investment when you hold it inside a Roth IRA.

“Remember, every dollar you end up making in a traditional IRA is taxed at ordinary income tax rates. And so you are potentially creating a tax time bomb by owning it inside a traditional IRA.

“You never want to own it inside a Roth. And you’ve got lots of problems owning it inside a traditional.”

Final Thoughts

Clark is adamant that investing in real estate inside an IRA is a bad idea. He even says he “hates” all self-directed IRAs.

If you decide to proceed, you face a minefield of rules, fees and potential penalties.

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