Using an IRA to buy investment real estate such as rental properties can be one of the best if not the best investment most people can make. This is according to an article published on USNews.com, it has become an increasingly popular investment option due mostly to the fact that real estate almost always increases in value. In fact, the price of new homes increased annually by an average of 5.4% from 1963 to 2008. So, if you had purchased a home for $150,000 in 1963 you will have seen a very nice return on your investment. And, of course, if you purchased a rental property you would have not only seen that annual average increase of 5.4% you would have also profited from the rental income.
What Most People Don’t Understand About IRAs
You undoubtedly know about Traditional IRAs and maybe even Roth IRAs. But did you know there was such a thing as self-directed IRAs? If you choose to have one of these you could invest your retirement income in just about anything including real estate, where you would enjoy several important benefits.
Your taxes on investment gains will be delayed
If you buy a rental property outside a self-directed IRA, you will be required to pay taxes on your rental income right away. You will also be required to pay taxes on the gain when you sell the property even if you plan on reinvesting that money in other investments. In comparison, with a self-directed IRA the taxes on your real estate income will be delayed so long as you keep the money in your retirement account. This should help you earn a higher after-tax return.
If you have a Roth IRA, then when you take a withdrawal after the age of 59 1/2 the money will be tax-free. This means if you invest in real estate with a Roth IRA you will not be required to pay taxes on your rental income, your gains from selling a property or your capital appreciation. The downside is that in exchange for this you will not receive a tax deduction on your contributions to the Roth IRA as you would with a traditional IRA. If you make a large real estate investment the tax-free growth you would get from a Roth IRA could be a better incentive than the tax savings you would get initially on a traditional IRA because those gains are taxable when you start to make withdrawals after you have retired.
Your growth will be leveraged
Another benefit of buying real estate through a self-directed IRA is that you don’t have to pay off the entire purchase all at once. You could pay off part of it and then take out a mortgage for the rest. If you do this, you could leverage your money through borrowing to earn a bigger return. For example, if you make a down payment of $100,000 to buy a $250,000 property you will be realizing rental income out of an asset worth $250,000. So even when you take into consideration the cost of borrowing the money your return should be higher than if you had just bought something worth $100,000. Even better, that return is growing tax-deferred in your IRA.
However, spoiler alert: When you purchase real estate with a mortgage in your IRA it can’t be titled in your name. It must be titled instead in the name of your IRA. In addition, it must be what’s called a non-recourse loan, which means the loan is backed only by the value of the real estate that’s paying for. If you were to default on the loan your lender could seize the property but at least this would have no effect on your personal credit or other assets.
Your rental income
Another big plus of buying a rental property is that you can rent it out and create a steady stream of rental income. You could use this income to pay off the mortgage and any other expenses incurred on your investment property. This means that all you really need to come up with is the down payment. If you realize rental income above and beyond your mortgage payments the money will stay in your IRA and will grow tax-deferred. You can then use this money for future investments. And, of course, when you retire you could continue to receive rental income to supplement your other retirement savings.
Do you have a dream retirement home? According to an article published on CNBC.com, renting is more common than homeownership for retirees. Your self-directed IRA could help you pay for that dream. When you buy real estate property through your IRA you can use the income from that property to pay off that dream home’s mortgage. You should be able to do this fairly quickly and effectively with your IRA tax savings. Then when you’re ready to bail out and retire you can move the property title from your IRA into your name. If you wait until you’re at least 59 1/2 to take the property out of your IRA, you won’t have to pay the 10% early withdrawal penalty. However, you cannot live on that property while your IRA still owns it as this can lead to tax problems. Of course, nothing is stopping you from driving by your dream home with a smile on your face knowing that it steadily being paid off with your rental income.
How to set up a self-directed IRA
Creating a self-directed IRA is not as simple as creating a traditional or Roth IRA. You need to create it as a business with your Secretary of State. It will be an LLC or Limited Liability Company. You should hire an attorney to prepare what’s called an operating agreement. Next, verify the agreement to make sure it meets the requirements for a self-directed IRA LLC as determined by your Secretary of State.
Find an IRA custodian
You’ll need to open your self-directed IRA with what’s called an IRA custodian. You will finance that IRA with funds or a transferred balance from an existing retirement account. Finally, you will need to work with your IRA custodian to begin the investment process. Your custodian will help you decide on the terms of your investment and then invest in the LLC. In most cases, you will need to establish what’s called a front end checkbook account to administer your self-directed IRA. This will be a special checking account to pay for all the expenses incurred by your real estate property as well as a place to deposit your rental income.