Yes, it is possible to hold rental properties within a retirement account, and many people do so to diversify their investment portfolio. This is typically done through a self-directed IRA (Individual Retirement Account). While this strategy offers some significant advantages, it also comes with specific rules and potential complexities that every investor should understand.
Setting Up a Self-Directed IRA
To get started, you’ll need to work with a specialized custodian. Unlike traditional IRAs that are managed by banks or brokerage firms, a self-directed IRA custodian is a third-party administrator that handles the record-keeping and IRS reporting requirements for your alternative assets, like real estate. These custodians typically charge a one-time setup fee and ongoing monthly or annual fees, which can range from $50 to $75 a month.
Key Requirements and Restrictions
Investing in real estate with a self-directed IRA comes with a few key stipulations. The first major requirement is that properties must typically be purchased with cash. This is because obtaining financing for these properties can be difficult. Any loan must be a non-recourse loan, which means the lender can only go after the property itself in the event of a default and not the IRA owner’s personal assets. Because of this added risk, non-recourse loans are not as common and are more difficult to secure than traditional mortgages.
Another critical rule is that the properties must be strictly for investment purposes. You, as the IRA holder, and certain “disqualified persons” (including your spouse, parents, and children) are prohibited from personally using the property for any reason, such as a vacation home or a personal residence.
The Advantages and Drawbacks
The biggest advantage of holding rental properties in a self-directed IRA is the tax benefit. Rental income and any appreciation on the property grow tax-deferred within the account. In a traditional self-directed IRA, you will pay taxes when you withdraw funds in retirement, but with a self-directed Roth IRA, your distributions in retirement can be completely tax-free. Deferring or eliminating taxes on your rental income can significantly boost your long-term returns.
However, there are also drawbacks. The administrative aspect can be cumbersome. Custodians have their own specific requirements, and simple tasks, such as handling rent payments or paying property expenses, can be more complex than with a personally held property. Our management company has extensive experience working with various self-directed IRAs and has learned to navigate these systems effectively, ensuring a smooth process for our clients. Despite the potential for administrative headaches, holding properties in a self-directed IRA can be a very rewarding investment strategy for a lot of property owners.