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How To Buy Real Estate In A Roth IRA

Choose FI has partnered with CardRatings for our coverage of credit card products. Choose FI and CardRatings may receive a commission from card issuers. Opinions, reviews, analyses & recommendations are the author’s alone, and have not been reviewed, endorsed or approved by any of these entities. American Express is a ChooseFI advertiser. Disclosures.

Did you know you can actually buy real estate in a Roth IRA? And it’s completely legal too, not the least of which since you can hold just about any asset in an IRA account. Some real estate promoters seriously pitch this option. And while it is certainly possible, you need to be fully aware that it’s also a very complicated process.

We’re going to do a high-altitude report on how to buy real estate in a Roth IRA. But be advised this is not the kind of investment strategy you should ever enter on the basis of an online article. The number of potential pitfalls and the severity of the IRS penalties makes this a very serious step. For that reason, you absolutely must consult with a knowledgeable CPA or tax attorney before moving forward. With that rule firmly in place, let’s take a look at the basics of how to buy real estate in a Roth IRA.

Why Hold Real Estate in a Roth IRA?

At least since the 1970s, real estate has rivaled the stock market in investment returns. In some decades, one has outperformed the other, but on balance, it’s been a tight race. Either way, a large number of people have become millionaires by investing in real estate. The reliable performance of real estate makes it an excellent long-term investment.

There are tax breaks that come with investing in real estate. Depreciation is an example. It’s a paper expense, that can be used to offset real income, giving the owner tax-free income.

Another is the long-term capital gains tax advantage. If investment real estate is held for more than one year and sold at a profit, the tax rate is between zero and 20% for most taxpayers. But can you imagine holding investment real estate in a Roth IRA, where it will be fully tax-deferred–until you turn 59 1/2 when it will become completely tax-free?

Whether tax-deferred or tax-free, neither the profit from rental income nor the windfall from capital gains will create a tax liability. Now think about how powerful that advantage will be over many years. That’s reason enough to consider holding real estate in a Roth IRA.

The Diversification Angle

Still another advantage is that real estate represents true diversification. Most retirement plans are loaded up with paper investments. That includes stocks, bonds, mutual funds, exchange-traded funds, and certificates of deposit. Those are all solid investments, but they’re also intangible.

It often makes sense to include some type of tangible asset in a retirement plan, particularly an IRA. They often perform better than paper investments, particularly during times of high inflation. Precious metals are an excellent example of a tangible investment. But the ultimate tangible investment is real estate. That’s because it’s not just an investment, but it also has a practical purpose. It provides shelter either for residential tenants or commercial businesses. That tends to give it staying power over the very long term.

Adding this kind of tangible investment to a portfolio of paper assets achieves a much greater level of diversification.

Related: Your Options For Investing In Real Estate

Buying Real Estate in a Roth IRA–The Downsides

No discussion of buying real estate in a Roth IRA is remotely complete without a solid discussion of the complications–and there are plenty. The first downside you’ll encounter is finding an IRA trustee who will hold physical real estate in a Roth IRA account. If it’s a trustee that has a well-known name, rest assured they won’t be a candidate. Real estate related IRAs are a special breed, and you will need to work with trustees who specialize in the field. There is only a handful, and we’ll list a few shortly.

Second, because of the high price of real estate, it will be very difficult to diversify within the asset class. Most investors will do well to hold one or two properties, especially in the early years, unless you’re rolling over large sums from other retirement plans. This will limit your ability to spread your investment–and your risk–across several different properties, in a way similar to how you diversify across many securities in each paper asset class you hold in your portfolio.

Third, IRS rules on holding real estate in any type of IRA are stiff. If you violate even one of them, the IRS can completely invalidate the IRA. They can force a distribution subject to ordinary income tax and the 10% early withdrawal penalty. This is a major reason why the vast majority of IRA trustees don’t accommodate physical real estate.

Specific Rules for Holding Real Estate in a Roth IRA

Here are some of the rules surrounding holding real estate in an IRA account:

  • You cannot be personally involved in the management of a real estate IRA. The account must be managed by the trustee. You and your real estate IRA will be completely distinct entities.
  • You cannot receive any benefits from the property held in the IRA. That means you can’t live in it, your family can’t live in it, and you can’t run a business out of it. There can be absolutely no personal use of the property.
  • The IRA cannot purchase property that is in any way connected with you or your family.
  • All financial activity, including both income and expenses, must go into or originate from the IRA. You cannot receive any income or pay any expenses for the property held in the Roth IRA.

In short, you can’t use real estate in a Roth IRA to build a personally directed real estate empire. You can only make the choice to start a real estate IRA, decide who the trustee will be, then fund the account. All management of the assets held in the account must be handled by the trustee. Violate that rule, and really bad things can happen.

How to Buy Real Estate in a Roth IRA

As you’ve probably already guessed, holding real estate in a Roth IRA is not nearly as simple as traditional paper assets.

First, you have to open a self-directed account with a trustee that specializes in real estate IRAs (see next section). Once you’ve made that selection, you’ll set up your account much the way you would any other self-directed Roth IRA. Once again, you cannot be personally involved in the real estate investment process. You will direct the Roth IRA trustee to invest in real estate, fund your account, then step back from the entire process.

Any real estate held within the Roth IRA must be legally titled in the name of the IRA account. It cannot in any way be connected with you personally (yes, I’m repeating that point, because it’s absolutely critical with real estate IRAs). You will have to complete forms specific to the IRA trustee, directing them to make property purchases within the account.

The funds to invest in real estate must come from the account. You will not be able to supplement the purchase or property management with funds from unrelated accounts. All income collected on the property must come into the IRA–not a single nickel can come to you personally. Similarly, all expenses must be paid out of the IRA account. Any profits generated by rental income must be retained within the account.

Selling Property Held in a Real Estate Roth IRA

When it comes time to sell the property, your only input will be to approve the sale price. This is similar to the process of approving the sale of a stock at a certain price in a conventional IRA account. However, all proceeds from the sale of the property will once again be retained within the IRA account.

All records pertaining to each property held in the IRA are also retained by the trustee. As you can see, it’s almost ironic saying that it’s a self-directed account. Other than selecting the trustee, funding your account, and agreeing to the sale price of a property, there’s really nothing self-directed about it. All activity and financial transactions are handled by the trustee.

Related: How Do You Know When To Sell A Rental Property?

IRA Trustees that Specialize in Real Estate IRAs

As already noted, very few IRA trustees will allow you to hold real estate in your Roth IRA. Not only is the process complicated, but the trustees themselves may also face various penalties for failing to get it right.

Below is a list of five trustees known to handle real estate IRAs. Please understand we are not making recommendations for any of these companies. Rather, we are offering this list as a starting point in your search for a suitable trustee.

Be sure to research each company through various third-party rating services, such as the Secretary of State, both in your state and the company’s home state, as well as the Better Business Bureau, Yelp, and other sources.

Also, thoroughly investigate what the company offers. You’ll need to know not only the degree of expertise they have in real estate IRAs, but also the specific processes they employ, and the fees they charge.

The five trustees known to specialize in real estate IRAs include:

How Mortgage Financing Works with Real Estate in a Roth IRA

If investing in real estate in a Roth IRA is a complicated process, it’s even more so if you attempt to borrow money to do it. It’s not that borrowing money to purchase real estate in a Roth IRA is impossible, but there are hurdles.

Once again, we need to stress that you don’t take this step without first consulting with either a CPA or a tax attorney. You should be aware that traditional mortgage financing for real estate is not available within an IRA account, traditional or Roth. This has much to do with the fact that any financing connected with an IRA account must be “non-recourse”. These are loans traditional mortgage lenders don’t like to make.

Under a non-recourse loan, the lender will be limited to the real estate only as collateral for the loan. Unlike a typical real estate mortgage, the lender won’t be able to pursue the other assets of either the IRA account or of the account owner. And no mortgage lender will grant a loan without your personal guarantee, which you cannot provide without violating the IRA.

To finance the property in a Roth IRA, you must work with a non-recourse lender. Naturally, those are few and far between. They also have very stiff requirements. For example, a non-recourse lender will require a large down payment, typically 50% or more.

And since you will not be able to provide a personal guarantee, the lender will need to be satisfied that the property generates sufficient cash flow to meet the monthly mortgage payment, as well as utilities, repairs, maintenance, and a reasonable estimate for a vacancy factor (times in which the property is without a tenant). And of course, the loan will be the obligation of the IRA, not of you personally.

A Financed Property in a Roth IRA May Be Required to Pay Tax

That leads to an even bigger complication. If you take financing, your real estate IRA may owe tax on unrelated debt-financed income (UDFI). The tax will be due on the percentage of the property value covered by the loan. So if 50% of the property value is financed, then 50% of the profits will be subject to the tax.

The IRA must then file a tax return (IRS Form 990-T). It will file as a trust, and pay trust tax rates since an IRA is, in fact, a trust. If you don’t want to go the financing route (and be subject to the UDFI tax), you do have some other options.

The most obvious, of course, is to fund the property purchase completely out of the funds from your Roth IRA. Now it will be close to impossible to do this if you’re funding your IRA at the normal contribution rate of $6,000 per year. The alternative will be to do either a rollover of funds from another Roth IRA or a conversion of plan assets from non-Roth accounts.

Still, another is to work with one or more partners on the same property. Each partner will have an undivided interest in the property.

If Actual Real Estate Scares You–REITs to the Rescue!

The acronym for real estate investment trusts, REITs are a lot “cleaner” to own than physical real estate. They’re also much easier to hold in a Roth IRA. You can hold them in much the same way you do stocks and other paper investments. The returns on REIT have been impressive for many years – sometimes outperforming stocks during a few periods but they’ve outpaced bonds for over 40 years. In fact, the only time period that small-cap stocks outpaced REITs is over the past year. REITs are a good way to invest in real estate in a Roth IRA and with a lot less complication and risk.

So if you’re thinking about holding real estate in your Roth IRA, first sit down and have a long, deep discussion with a CPA or tax attorney. Then consider if you have both the funds and the temperament to invest in physical real estate. If that all checks out, contact one of the real estate IRA companies that specialize in that investment, and move forward. But if you’re not willing to endure the complication and the risk–
but you still want to hold real estate in your Roth IRA–take a good, hard look at REITs.

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How To Buy Real Estate In A Roth IRA
Choose FI has partnered with CardRatings for our coverage of credit card products. Choose FI and CardRatings may receive a commission from card issuers. Opinions, reviews, analyses & recommendations are the author’s alone, and have not been reviewed, endorsed or approved by any of these entities. American Express is a ChooseFI advertiser. Disclosures.
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