What’s a self-directed IRA?

A self-directed IRA isn’t a different type of IRA. Rather, the term refers to any individual retirement account (traditional or Roth) that gives you more investment control by allowing you to direct your IRA assets into nontraditional investments.

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 your IRA is life insurance. (Collectibles–for example, artwork, stamps, wine, and antiques–aren’t prohibited, but if your IRA purchases these items, you could suffer adverse tax consequences.)

To get started, 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 tax consequences.

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.

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. 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.

Can my self-directed IRA invest in real estate?

Yes. Your 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 multi-family home, commercial property, raw land, 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 (unrelated business income tax) 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. 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 may make the Roth IRA an attractive vehicle for real estate ownership.

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 other costs.

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.