Just because a self-directed IRA allows you to choose certain investments, it doesn't mean that you should. Some investment choices aren't suitable for all investors.
Certain risks are involved in investing in real estate. Changes in real estate values and economic downturns can have a significant negative effect on real estate investments, including REITs, mutual funds, and ETFs. Rising interest rates (which can impact the cost of borrowing), declines in real estate values in general, and other factors including property taxes, zoning laws, demographic changes, and natural disasters can all negatively impact the value of your investment property.
A self-directed IRA isn't a
different type of IRA.
Rather, the term refers to
any individual retirement
account (traditional or Roth)
that allows you to direct the investment of your IRA assets into
For example, in addition to the usual IRA
mainstays (stocks, bonds, mutual funds, and
CDs), a self-directed IRA might invest in real
estate, limited partnership interests,
or anything else the law (and your IRA trustee/custodian) allows. In fact, the only investment
you can't have in an IRA is life insurance.
Collectibles (e.g., artwork,
stamps, wine, and antiques) aren't prohibited,
but if your IRA purchases these items, you
could suffer adverse tax consequences.
First, you'll need to find a trustee or
custodian that specializes in self-directed
IRAs. Make sure you understand the expenses
involved — some trustees charge transaction
fees and/or asset-based fees, depending on the particular investment.
You also need to be aware of the prohibited
transaction rules. These rules are designed to
make sure that only your IRA, and not you (or
your immediate family), benefits from your
IRA transactions. For example, you are prohibited
from buying investments from, or selling
investments to, your IRA. If you violate
these rules, your account will cease to be
treated as an IRA, with potentially devastating
Finally, you need to understand the UBIT
(unrelated business income tax) rules. Even
though IRA investments usually grow tax deferred
(or even potentially tax free in the case
of a Roth IRA), if your IRA conducts certain
business activities or has debt-financed income,
then your IRA could be taxed currently
on all or part of the income generated.
Investing in real estate
Your self-directed IRA can invest in virtually any form
of real estate. That includes direct ownership
in property as well as indirect ownership
through limited partnership interests, REITs,
and mortgage obligations. Your IRA can buy a
beach house, a multifamily home, commercial
property, raw land, time shares, condos,
an island — almost anything. Your IRA can be
the sole owner of the real estate, or a partial
owner with others.
Your IRA can even borrow money to purchase
real estate. However, it may be difficult to find
a bank that will lend money to your IRA (since
you can't personally guarantee the note). Borrowing
may also cause some of the income
(or sales proceeds) from the property to be
taxed currently to your IRA under the UBIT rules.
When you invest in real estate, you'll also need
to pay particular attention to the prohibited
transaction rules. You can't, for example, sell
property you already own to your IRA. And
neither you nor certain family members can
use real estate while it's owned by your IRA.
As discussed below, that sort of self-dealing can result in your
entire IRA becoming taxable to you.
Keep in mind that when you hold real estate in
a traditional IRA, you'll have to pay tax at ordinary
income rates when your account is ultimately
paid out to you — whether you receive
cash or the property itself.
Qualified distributions from a self-directed
Roth IRA, on the other hand, are free from
federal income tax, which makes the Roth IRA
an attractive vehicle for real estate ownership.
Say you've found your dream retirement
home. It may be possible to have your Roth IRA purchase
the property, rent it out to an unrelated party to generate
income, and then, when you're ready to retire,
have the IRA distribute the property (and any
income) to you tax free. (A distribution is qualified if you satisfy a five-year holding period and you're either age 59½ or disabled when you receive the distribution.)
Finally, note that you'll need to pay any expenses
related to your real estate investment
out of your IRA, so make sure it will have
enough cash each year to cover any real estate
taxes, legal fees, repairs, insurance, and
What are prohibited transactions?
Generally, a prohibited transaction is any improper use of an IRA account or annuity by you, your beneficiary, or any disqualified person.
Disqualified persons include IRA fiduciaries (see below) and members of your family (spouse, ancestor, lineal descendant, and any spouse of a lineal descendant). The following are examples of prohibited transactions with an IRA:
- Borrowing money from it
- Selling property to it
- Receiving unreasonable compensation for managing it
- Using it as security for a loan
- Buying property for personal use (present or future) with IRA funds
For this purpose, a fiduciary includes anyone who does any of the following:
- Exercises any discretionary authority or discretionary control in managing your IRA or exercises any authority or control in managing or disposing of its assets
- Provides investment advice to your IRA for a fee, or has any authority or responsibility to do so
- Has any discretionary authority or discretionary responsibility in administering your IRA
Consequences of engaging in a prohibited transaction
Generally, if you (or your beneficiary after your death) engage in a prohibited transaction at any time during the year, the account stops being an IRA as of the first day of that year. The account is also treated as distributing all its assets to you at their fair market values on the first day of the year. For a traditional IRA, if the total of those values exceeds your basis in the IRA, you'll have a taxable gain that's includible in your income. If you're not yet age 59½, the 10% premature distribution penalty tax may also apply. The IRS hasn't yet provided specific guidance describing how these rules apply to Roth IRAs. However, it's probable that if you've satisfied the requirements for a qualified distribution, the distribution will still be tax free. A nonqualified distribution from a Roth IRA will result in a taxable gain to the extent the distribution exceeds your Roth IRA contributions (and again, the premature distribution penalty tax may apply if you haven't yet reached age 59½).
What is UBIT?
UBIT stands for "unrelated
business income tax." While
not common, it can apply to
your traditional (and Roth)
IRA. (The UBIT rules also
apply to most
employer retirement plans and tax-exempt
In simple terms, if your IRA regularly conducts
a trade or business (for example, you buy and
operate a bakery using IRA funds), then the
income from that trade or business (less any
expenses directly connected with carrying on
the trade or business) is subject to UBIT. The
IRA is taxed on the income (unrelated business
taxable income, or UBTI) at trust tax rates.
The term "trade or business" is defined as any
activity carried on for the production of income
from selling goods or performing services. This
has been broadly interpreted to apply even if an
IRA doesn't directly conduct a business, but
instead invests in a pass-through entity, like
a partnership, that conducts a trade or business.
If an IRA invests in a partnership that conducts
a trade or business, then the IRA must
calculate its UBTI based on its share of the partnership's gross income and deductions.
This information is provided by the partnership
to the IRA on Schedule K-1.
There are numerous exclusions from the
definition of UBTI, including dividends, interest,
annuities, royalties, and rents from real
property. However, even otherwise exempt income can
become subject to UBIT if the property is
acquired with borrowed funds. For example, if
your IRA purchases real property and finances
the purchase with a mortgage, any rental
income attributable to the financed portion of
the property will be UBTI, even though that
rental income would otherwise be exempt.
An IRA needs at least $1,000 of gross income
from unrelated businesses for the UBIT to
apply. The IRA itself is responsible for paying
the tax. This may result in double taxation as
the income will be subject to tax again, under
the regular IRA distribution rules, when
ultimately distributed from the IRA (although
qualified distributions from Roth IRAs will be tax
As you can see, a self-directed IRA can provide you with almost unlimited investment flexibility, but also presents some traps for the unwary. Your financial professional can help you
weigh the benefits and risks of a self-directed
IRA, and help you determine if it's the right
choice for you.