What Is a Real Estate IRA, and Is It Right for You?

What Is a Real Estate IRA, and Is It Right for You?

Growing your retirement nest egg sometimes means thinking outside the nest. If you have income that you've earned, you can access individual retirement accounts (IRAs) to grow your investments in tax-smart ways over long periods of time.

An IRA gives you a number of options in terms of what you can buy with your contributions. For instance, standard IRAs focus on stocks, bonds and mutual funds. While these investments can deliver suitable returns for growing your wealth, you might also want access to other types of assets.

One alternative asset class to consider is real estate, which you can capitalize on by investing in a real estate IRA, or what the IRS formally calls a self-directed IRA (SDIRA). Real estate has traditionally served as a good long-term investment choice, and a real estate IRA comes with its own special benefits for growing your retirement. However, it also brings its own set of challenges that could defeat the entire purpose of investing if they aren't handled carefully.

Here we will discuss what a real estate IRA is, how it differs from more common types of IRAs and when a real estate IRA might make the most sense for you.

What Is an IRA?

An IRA is an investment account that allows you to set aside money in a tax-advantaged manner for retirement. There are many types of IRAs available to meet your individualized needs, but they come in two main flavors:

  • Traditional IRAs: You fund these accounts with pretax dollars (up to $6,000 per year or $7,000 if you're 50 or older) and pay taxes when you withdraw money in retirement.
  • Roth IRAs: This type of IRA is funded by after-tax dollars that grow tax-free through retirement.

Both types of IRAs allow you to invest in traditional financial assets like stocks, bonds and mutual funds. If you'd like to expand your investments to less traditional financial assets like real estate, you'll need to consider opening an SDIRA. These accounts come with special rules but can open up your portfolio to more investment options.

What Is a Real Estate IRA?

The term "real estate IRA" is commonly used to refer to an SDIRA. These IRAs allow you to invest in real estate, but you'll likely want to be an experienced real estate investor before you do so, as you'll need to follow many rules to keep the tax-deferred status for your SDIRA, and losing this could be an expensive mistake.

These rules from the IRS relate to prohibited actions that you cannot take with an SDIRA, and violating them would mean having to pay a tax that negates the original tax benefits of the account.

The IRS rules include the following:

  • You can't carry a mortgage on the property.
  • You can't do renovation work yourself and would need to a hire a third party.
  • You can't claim depreciation or otherwise operate the property at a loss and receive a tax break.
  • You can only pay for expenses related to the property with account funds. Rental income remains in the account, and not having enough money for major expenses can put you in a problematic situation.
  • You can't receive any personal benefit from the property.

You'll need to make sure you don't run afoul of these rules to guarantee the tax-advantaged status of your SDIRA. Engaging in a prohibited transaction will cause it to lose this benefit.

Should You Invest in a Real Estate IRA?

You can only contribute up to the annual limit with an IRA, so if you contribute to an SDIRA for many years and then take part in a prohibited transaction that costs your account its tax-advantaged status, you would have been better off investing in real estate outside of an IRA or putting those funds toward traditional financial assets through an IRA with ongoing tax benefits.

While SDIRAs can be lucrative for some investors, the rules that govern them make them riskier than regular IRAs. However, if you understand those rules, have a healthy capital cushion inside the account, and can find a worthwhile real estate investment, using a real estate IRA may be worth the risk.

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