The downside of buying real estate with your IRA

Most people are familiar with a traditional IRA, the type you can create through a brokerage like Schwab, E-Trade or Fidelity. But you are not allowed to buy real estate with a traditional IRA. Instead, you need to set up a self-directed IRA through a specialized company, which acts as the custodian.

Caution is advised: If the self-directed IRA is set up incorrectly, you could be on the hook for unexpected tax liabilities, and in some cases, penalties, so hiring an experienced real estate lawyer to help with the process is a must.

The IRS also has very specific rules regarding real estate investments in an IRA, and if you fail to strictly adhere to them, they can disqualify your IRA, making all the funds and transactions taxable.

IRS rules prohibit individuals from engaging in “self-dealing” in their IRA. This is a catchall term, which generally means you can’t do business with yourself or engage in any transactions that provide you with financial benefit, instead of your IRA.

The rules run from straightforward – you can’t buy or sell property with your IRA to a related party – to extremely complex. For example, if you use $250,000 from your IRA to invest in a rental property and then let your daughter and her family move in, even if they pay rent, the investment would be considered a prohibited transaction. If discovered, the IRA could rule the $250,000 investment a distribution and you would be liable for any subsequent taxes and penalties.

The IRS also requires that any real estate owned in your IRA be strictly for investment purposes only. That means you and your family members cannot use it for personal reasons – under any circumstances.

So, if you buy a property to list on Airbnb or a similar service, and you or your family members stay there when it isn’t rented, that would be a violation of the rules.

In addition, all expenses for your property, including, but not limited to repairs, utilities, taxes, homeowner association fees and insurance, must be paid with funds from your self-directed IRA. You cannot pay them yourself, which means you’ll need to have plenty of cash in your account. And any income generated by your investment property cannot be paid to you – it must be paid directly to your IRA.

Another restriction on property held in an IRA is that you are not allowed to do any improvements yourself. That even includes something as simple as fixing a leaky faucet. Doing so is considered a prohibited transaction. You are even prohibited from using furniture you own personally to furnish your investment property.

But it’s not just the complex financial structure and strict management rules that make buying real estate with an IRA a less attractive option for most people. There are also numerous disadvantages to this strategy, like concentrated risk.

Because real estate is an illiquid asset, seniors must consider how they will deal with Required Minimum Distributions once they reach their required beginning RMD age. Once they reach that age, they’re required to take annual withdrawals from all their tax-deferred accounts. Those withdrawals are based on the year-end balance of their IRAs, which means each year they will have to have an appraisal done on their investment property to make sure those withdrawals are accurate.

“This brings up another disadvantage,” says Muhammed. “Appraisals are expensive. And that’s just one of the many fees associated with owning property in an IRA. There are fees to set up a self-directed IRA and most custodians charge for check requests, fund transfers and other transactions, in addition to an annual management fee.”

And in an ironic twist, one of the main drawbacks with this investment strategy is that you forego numerous tax breaks normally associated with owning real estate, like depreciation and interest write-offs.