The Self-Directed IRA: A Powerful Real Estate Investment Tool
Written By: Jason Bailey
Self-directed individual retirement accounts are one of the most underutilized and misunderstood investment vehicles available to the American workforce. Many are unaware that funds within a self-directed IRA can be used to invest in some powerful and diverse investment assets other than stocks and bonds. In this article, we’ll talk briefly about how retirement funds inside a self-directed IRA (SDIRA) can be used to invest in commercial real estate.
What is a self-directed IRA?
In 1974, Congress enacted the Employee Retirement Income Security Act (ERISA) to shift the responsibility of retirement savings away from the employer and put employees in greater control of how their funds were invested. Individual Retirement Accounts (IRAs) were created the following year, ushering in a new era of retirement planning. One of the attractive investment options was the self-directed IRA, which is a retirement account owned and controlled by the account holder. While this type of account is held by a custodian, the choice of investment is made by the account holder.
Eligible investment classes include:
Stocks and bonds
Real estate
Partnerships
Precious metals
Intellectual property
Private businesses
Private Equity
Debt products
What an IRA is and isn’t
There are some common misunderstandings about IRA’s. For clarity, we’ll outline these below:
An IRA is a retirement account owned by an individual.
It is NOT a 401(k), which is a retirement account set up by a company for its employees. These accounts are much more prevalent than IRAs, but 401(k)’s cannot be used in real estate transactions as IRA’s can. With that said, as soon as an employee leaves a company, that 401(k) retirement account becomes an IRA. This happens when the employee retires or leaves the job for any reason.
An IRA (traditional or Roth) is not a SDIRA. Just because a person has an IRA from an old job does not mean that they can invest that IRA into real estate directly. An IRA is managed by a financial planner, while a SDIRA is managed by the account holder. In order to invest in real estate, these IRA funds will need to be rolled over into a SDIRA.
Some limitations of the SDIRA
People who are ineligible to make money using an account holder’s SDIRA are called disqualified persons. It is important to be familiar with this concept in order to avoid heavy fines and penalties! Disqualified persons cannot be the borrower of the funds, they cannot own a piece of the investment outside of the SDIRA, they cannot take a fee from an SDIRA transaction, and they cannot be a person who can make money or otherwise benefit from the IRA’s investment activities.
Disqualified person #1: Account Holder
Account holders get the long-term benefit of having the retirement account at work in an investment project. The account holder’s benefits can only be realized at retirement, not before.
Disqualified person #2: Lineal ascendants
The account holder cannot lend the money to parents, grandparents, or anyone ascending the family tree.
Disqualified person #3: Lineal descendants
The account holder cannot lend money to children, grandchildren, or anyone descending the family tree.
Why SDIRA’s are great real estate investment tools
Two rules of SDIRA’s make them powerful real estate investment tools:
Rule 1: Account holder cannot touch SDIRA funds until retirement
Rule 2: Income tax is not paid annually
The great benefit of not being able to touch SDIRA funds until retirement is that the account holder is not taxed annually on this investment. Thus, compounding interest can accrue on capital gains in IRA investments - tax-free - until it is drawn on at retirement. This becomes fuel for the exponential growth of your IRA!
Compounded Interest: Rule of 72
Einstein discovered a rule around compounding interest, called the Rule of 72. The Rule of 72 goes like this: If you take an investment that is compounded annually and divide the interest rate into the number 72, the result you will get is the number of years it will take that money to double.
Rule of 72 Example: Jackson
Jackson is a 35-year-old dentist who invests $100,000 in a commercial multifamily syndication property with an annualized interest rate of 14%
Using the rule of 72, Jackson’s investment will double roughly every 5 years
At 40, Jackson will have $200,000
At 45, Jackson will have $400,000
At 50, Jackson will have $800,000
At 55, Jackson will have $1,600,000
At 60, Jackson will have $3,200,000
At retirement at age 65, Jackson will have $6,400,000!
Jackson’s $100,000 investment accrued to a $6.4 million fund tax-free until retirement! That’s a pretty good return.
The Solo 401(k) option
A solo 401(k), is a SDIRA-like account geared for those who are self-employed. It bears many similarities to the SDIRA. Both were created by Congress for individuals to save for retirement and both may be invested in alternative investments such as real estate, precious metals, tax liens, promissory notes, private company shares, and stocks and mutual funds, to name a few. The key differences are that self-employment, whether on a part-time or full-time basis, is required to open a Solo 401(k). Like the SDIRA, a solo 401(k) participant/owner may not serve as trustee or custodian; instead, a Trust Company or Bank is required.
How to secure a SDIRA custodian?
SDIRA’s are a niche market, thus are not offered by many of the largest financial investment firms. Some factors to consider when selecting a SDIRA custodian include experience, fees, expertise, cyber-security, and BBB rating. Some of the more reputable companies that offer custodial SDIRA services include:
References
Faircloth, Matt. Raising Private Capital: Building Your Real Estate Empire Using Other People's Money (Kindle Locations 1088-1091). BiggerPockets Publishing. Kindle Edition.
Brandon, Emily. (Dec 2018). 11 Ways to Avoid the IRA Early Withdrawal Penalty. https://money.usnews.com/money/retirement/slideshows/ways-to-avoid-the-ira-early-withdrawal-penalty?slide=4
Daniel, Kurt (March 2019). Finding a Custodian for a Self-Directed IRA. https://www.investopedia.com/retirement/finding-custodian-selfdirected-ira/
Pensco, (Dec 2017). Tax-Advantaged Real Estate Investing. Retrieved from http://go.pensco.com/rs/925-CQD-842/images/PENSCO_InvestorsGuide_RealEstate_0115%20%281%29.pdf?mkt_tok=eyJpIjoiWXpReVlqbGxOVGt5WmpCbSIsInQiOiJMb245VnFDbXhtWjhcLzREWjdBT2sxN2JTNlRMbGVCMkV5cWM2THpSbnZJMm1nSlVDTzRnTUM3Q0hcLzJFaVVycElJN3BHUXpTSFRcL04zR1cwajZreDByMVo2Q0ZYS1BcLytEd1EzVFhiT0N6RkhWU0RiMkVCK3NZRWM1S1hUUExENFQifQ%3D%3D
IRS Publication: publication 590-A Cat. No. 66302J