Direct Real Estate in an IRA – the Pros and Cons 

If you’re considering investing in direct real estate, it’s crucial to be aware of important factors that can help with avoiding potential pitfalls. You’ll also want to understand the difference between investing in direct real estate vs. REITs (real estate investment trusts). 

What is direct real estate? 

Direct real estate refers to the purchase or investment in physical properties including residential, commercial, or industrial. If you see a real estate fund in your individual retirement account (IRA), it is not direct real estate but an indirect investment in real estate usually through a REIT. 

Currently, the only way to purchase direct real estate in an IRA is to open a self-directed IRA (SDIRA) with a financial institution that holds securities and allows such an account. Be aware that the financial institution, often referred to as the custodian, is providing a service and will likely have fees for buying the property. Once the account is open you can transfer funds from your existing IRA into the SDIRA to conduct the real estate purchase. 

Benefits of direct real estate 

• Tax advantages: This is not specific to real estate in IRAs — as long as you don’t perform any disqualifying events (see the drawbacks below) you can maintain the tax advantages provided by the IRA.  

• Diversification: If you do not currently have any exposure to real estate in your investments and are not interested in real estate funds via REITs, this is one way to gain exposure to the sector. 

• Growth potential: If you are experienced in real estate investing and see a great opportunity but lack the capital outside of your IRA to make a purchase, this could be an option for potential investment growth. 

• Income potential: Depending on the type of property purchased, you may potentially receive a healthy income stream. 

Drawbacks of direct real estate 

• Self-dealing and prohibited transactions: You must avoid self-dealing and prohibited transactions — illegal acts by a fiduciary acting in their own best interest and not their client’s. This means you and your family can’t use or work on the property, and you can’t buy a property you own with the IRA or sell a property to the IRA. You should think of this solely as an investment and keep it at arm’s length. If you are found to be directly benefiting in your SDIRA, the account could lose its tax-protected status and become entirely taxable. Be sure you are well-versed in this aspect of an SDIRA before making a direct real estate investment. 

• Financing: If you need to use financing for the purchase, banks will not offer traditional financing to an IRA. They will likely offer a non-recourse loan which will use the property as collateral and often requires more money down with a higher interest rate. Further complicating the financing picture is UBTI (unrelated business taxable income). UBTI can be added onto the financed portion of the property and the income tax rates could be quite significant. 

• Liquidity risk: Since the IRA owns the property, all of the expenses must flow through the IRA. This means you need to maintain a cash cushion in the account to avoid any cash shortfalls that may occur from paying expenses. Depending on your situation you could make an IRA contribution to help support a potential cash shortfall. An additional consideration for liquidity is the time it might take to sell property. If you need to make a withdrawal from the SDIRA, you can’t sell part of a house. This becomes even more of an issue once you reach the age of required minimum distributions (RMDs), which is 73 in 2024. You could be forced to sell out of an entire property at an inopportune time to meet RMD amounts. Even when taking cash from the account, make sure you leave an appropriate amount to support the expenses of the property.  

• Concentration risk: Where there is growth potential there is risk. Be aware that you are making a significant investment in one “position.” This risk is lessened if you are only putting a small portion of your IRA assets into this strategy. However, if you are investing a significant amount of your IRA funds into this strategy, you could be jeopardizing the success of your financial plan on the performance of a single property.  

• No tax loss benefits: Most real estate investors experience a tax loss each year, primarily due to depreciation deductions. Depreciation is a noncash “expense” of paying off the purchase price over time. Since most properties appreciate, the depreciation isn’t actually an expense but creates an annual tax benefit. Inside the IRA, these losses are trapped within the tax deferred wrapper. 

Final thoughts 

Direct real estate in an IRA is not an investment approach meant for everyone. There is potential to make missteps and overcomplicate your retirement picture. If you are savvy in real estate and are aware of a great deal but lack funds outside of your IRA to make a purchase, this strategy could be appealing for a portion of your overall retirement picture. 

There’s one consideration that tends to be overlooked. Under current rulings, if your child or other beneficiary inherits your IRA with a property inside, they will not only have to make RMDs if you were making them, but they will have to fully distribute that IRA’s assets by the end of 10 years after your death. If the IRA gets distributed to multiple beneficiaries, they may have to sell the property at an inopportune time such as during a buyer’s market. 

You should think about the end goal. The point of an IRA is to invest for retirement. If you like the idea of owning a specific property, this approach might seem like a good fit, but you can’t use or work on the property. If you are simply looking to invest in real estate, there are indirect real estate or REIT funds that can help accomplish that goal more effectively.  

Want to learn more? 

At Mercer Advisors, we offer a comprehensive wealth management solution that integrates investment management along with financial planning, tax planning, estate planning, and insurance solutions. Because your finances work better when they work together. No matter what stage you’re in for building your wealth, Mercer Advisors can help. If you want to learn more about direct real estate investments, REITs, and related topics, let’s talk.