Self-Directed IRAs (SDIRAs) have become an increasingly popular tool for investors seeking greater control and diversification within their retirement portfolios. One of the most attractive alternative investment options within SDIRAs is real estate—offering the potential for long-term appreciation, rental income, and tax-deferred growth. However, using a Self-Directed IRA to invest in real estate also comes with notable limitations and risks.
Below, we’ll explore the advantages and disadvantages of using a SDIRA to purchase real estate investment properties so you can make an informed decision.
Pros of Using a Self-Directed IRA for Real Estate
Tax-Advantaged Growth
Just like traditional IRAs, investments made through a SDIRA grow tax-deferred (Traditional SDIRA) or tax-free (Roth SDIRA). This means any rental income, appreciation, or capital gains generated by the real estate are not taxed annually, allowing earnings to compound more efficiently.
Portfolio Diversification
Investing in real estate allows retirement savers to diversify beyond traditional stocks, bonds, and mutual funds. Real estate often behaves differently than equities, helping to reduce overall portfolio risk and increase potential returns.
Control Over Investment Choices
With a SDIRA, you gain direct control over your investment decisions. You can choose what type of real estate to invest in—residential rental homes, commercial buildings, raw land, mobile home parks, and even farmland—based on your knowledge, market analysis, or strategic goals.
Potential for Strong Returns
Historically, real estate can generate significant returns through a combination of rental income and appreciation. For experienced investors, the ability to spot undervalued or high-demand properties can lead to outsized returns compared to traditional retirement investments.
Asset Protection
Real estate held in an IRA is typically protected from personal creditors, offering a layer of asset protection not found in many other investment accounts.
Cons of Using a Self-Directed IRA for Real Estate
Complex Rules and Prohibited Transactions
The IRS imposes strict rules on what you can and cannot do with SDIRA-owned real estate. For example:
You cannot live in, rent, or personally benefit from the property.
You cannot do the work yourself or hire disqualified persons (like family members) to perform repairs.
All income and expenses must flow in and out of the IRA—no co-mingling of personal and IRA funds.
Violating these rules can lead to severe penalties, including disqualification of the IRA.
Lack of Liquidity
Real estate is an illiquid asset, meaning it can take time to sell if you need cash in the account. This can be particularly problematic if you need to take Required Minimum Distributions (RMDs) in a Traditional SDIRA and don’t have sufficient liquid assets.
No Mortgage Deductions or Depreciation
Unlike personally owned investment property, real estate held in an IRA does not benefit from mortgage interest deductions, depreciation, or 1031 exchanges. This limits the tax efficiency of some common real estate strategies outside of an IRA.
Financing Challenges
If you want to finance a real estate purchase through your IRA, the loan must be non-recourse—meaning the lender cannot go after your personal assets if the loan defaults. These loans are harder to obtain, have stricter terms, and usually require larger down payments (30-50%).
Additionally, financing real estate in an IRA may trigger Unrelated Business Income Tax (UBIT), which can reduce the tax advantages.
Ongoing Fees and Administrative Burden
SDIRAs are typically held by specialized custodians who charge setup fees, annual fees, asset fees, and transaction fees. On top of that, managing a real estate investment within an IRA requires meticulous record-keeping and compliance.
No Personal Benefit
You cannot stay in the property—even for one night—or use it as a vacation home. The investment must be entirely passive and for the benefit of the IRA, not the account holder.
When Might a Self-Directed IRA Be a Good Fit for Real Estate?
A SDIRA might be an excellent vehicle for real estate investment if:
You are well-versed in real estate or work with a professional who is.
You have a larger balance in your retirement account and want to avoid market volatility.
You want alternative asset exposure in a tax-advantaged account.
You understand (or are willing to learn) the compliance requirements and are comfortable working with a SDIRA custodian.
Using a Self-Directed IRA to purchase real estate can be a powerful way to build retirement wealth—if used correctly. It offers significant upsides, such as tax-deferred income and portfolio diversification. However, it’s not without complications, including tax implications, strict rules, and the burden of illiquidity.
Before proceeding, it’s wise to:
Consult with a tax advisor or financial planner experienced in SDIRAs.
Work with a reputable IRA custodian.
Fully understand your responsibilities as an investor.
As with all retirement strategies, due diligence and professional guidance are key to avoiding costly mistakes.