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Investing a Self-Directed IRA in Real Estate: The Basics
January 2 | 2017

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Among the various individual retirement account (IRA) options, one of the least discussed and most misunderstood is the self-directed IRA. Indeed, when they hear the term self-directed IRA, many people confuse this vehicle with the standard types of IRAs — the Roth IRA and the SEP IRA, for example — because those IRAs allow the investor to exercise some degree of control over the investments in their account.

But a self-directed IRA is a distinct category of retirement account, different in several ways even from other IRAs. This page will discuss what a self-directed IRA is, the potential benefits and risks involved in such an account, and what types of unique investment opportunities it affords.

What is a Self-Directed IRA?

A self-directed IRA is an individual retirement account in which you, the investor, maintain total control over and responsibility for the investments in your account. And whereas standard IRAs offered through financial institutions limit your investment options — typically to stocks, bonds and mutual funds — with a self-directed IRA you can invest in a wide range of investment vehicles, such as precious metals and real estate.

Self-Directed IRA vs. Self-Managed IRA

One reason for the confusion about self-directed IRAs is that the term is often used interchangeably with the term self-managed IRA, but these terms in some cases can refer to very different types of retirement accounts.

The term self-managed IRA is often (although not always) used by brokerage companies and trading platforms to refer to traditional IRAs that allow the account holder some freedom in selecting her own investments within the account. In this sense, the self-managed IRA offers more control than an IRA managed by a licensed broker who selects assets to invest in on behalf of the account holder.

But in most cases, even though these self-managed IRAs allow the investor to make the investment decisions within her account, these are still a subcategory of the traditional IRA vehicles, where the account holder is limited in the types of investments allowed — generally stocks, bonds, mutual funds, treasuries, etc.

A self-directed IRA, by contrast, involves the investor placing his money with a custodian who is responsible only for executing the investments that the account holder requests. This custodian does not act as a financial advisor or a party responsible for finding and suggesting specific investments for the account holder.

Moreover, because this type of retirement account is treated differently from other types of IRAs by both the financial industry and regulators, the self-directed IRA allows the account holder to make investments in many asset classes not legally allowed by other IRAs — assets including limited partnerships, private placements for businesses, tax lien certificates, gold, traditional real estate investments, and today even real estate crowdfunding deals.

With a self-directed IRA, then, there are two primary distinctions from other types of IRAs.

  1. The owner of the self-directed IRA is fully responsible for deciding how and where to invest the money he places in his account.
  2. The self-directed IRA holder has much more freedom in the asset categories in which he may invest his IRA than does the owner of a traditional IRA.

What is a Self-Directed IRA Custodian?

Because your self-directed IRA will require one, you should understand what a custodian is, what they are responsible for doing in terms of maintaining your retirement account — and what they are not responsible for doing.

Here is how the Retirement Industry Trust Association (RITA) describes the role of a custodian in a self-directed IRA:

A directed IRA custodian serves as a passive, non-discretionary custodian of customer-directed, also known as self-directed, individual retirement accounts (“IRAs”), as IRA is defined in Section 408 of the Internal Revenue Code as amended. In its role as a passive custodian, a directed IRA custodian solicits no investments, and provides no advice or recommendations to customers with regard to investments, acquired by or held in the IRAs. A directed IRA custodian has no authority to take any action with regard to the investments acquired by or held in the IRAs without the express direction of the IRA owner.

“A directed IRA custodian occupies a unique position in the financial services industry. It is not a broker, or an investment advisor. It does not sell investments, determine suitability or provide due diligence on investments for the IRA owner. What the directed IRA custodian does is execute investment directions from the IRA owner, and perform the many custodial and administrative duties that are necessary to preserve the tax-deferred status of an IRA and otherwise administer the account and custody the assets.”

This is perhaps the most important component to understand about a self-directed IRA — knowing upfront that you will be entirely responsible for the decisions you make regarding how your account is invested and the quality and performance of the investments you direct your custodian to execute.

What are the Potential Benefits and Drawbacks of a Self-Directed IRA?

The Potential Benefits of a Self-Directed IRA

If you are a knowledgeable investor with a strong understanding of certain asset classes, or if you simply want to take an active role in managing your own retirement account to protect or grow your wealth, a self-directed IRA might be the right vehicle for you.

Additionally, if you feel positively about the long-term-growth potential of certain types of asset — assets that are not allowed as investments in traditional IRAs — you might also find that a self-directed IRA is right for you. Indeed, a self-directed IRA might be the only way to invest in such assets while enjoying the tax and regulatory benefits of a retirement account.

For example, many investors feel strongly about the long-term wealth-building potential of investing in real estate. But other than a few traditional, publicly traded Real Estate Investment Trusts (REITs) or public companies in the real estate industry (developers, for example, or construction companies), many traditional IRAs do not have any options for investing directly in real estate deals.

With a self-directed IRA, though, account holders can place their retirement investment capital directly into real estate opportunities — including, as of recently, investing in professionally vetted, dividend-yielding real estate crowdfunding deals

Moreover, because self-directed IRAs allow for more direct investments — in real estate, in gold, in an early-stage company raising capital through a private placement offering — such investments allow for the possibility of larger profits.

Of course, these investments, like all others, carry risk, and no asset class or investment category can guarantee positive performance. This is one reason that self-directed IRAs might not be the best type of retirement account option for everyone, which leads us to the possible drawbacks of such IRAs.

The Potential Drawbacks of a Self-Directed IRA

Self-directed IRAs can carry greater risk for investors in two ways. First, as just discussed above, a self-directed IRA allows the investor to make investments within her account in many sorts of non-traditional assets, assets not allowed in the more standard IRAs. These types of investments can offer the potential for greater profit, but can also carry a greater risk of loss. 

The second way self-directed IRAs might be riskier than traditional IRAs is in the lack of professional financial advice and guidance that often come with standard IRAs issued by financial institutions.

Indeed, when you manage a self-directed IRA, you are the sole party responsible for vetting any investment you make, and for learning about the tax or regulatory implications of that investment. If you make a mistake — for example, buying a rental property within your self-directed IRA and then renting a unit for yourself, which is not allowed — you are responsible for the penalties and other negative consequences that arise from that mistake. You cannot blame your custodian or anyone else.

Investing a Self-Directed IRA in Real Estate: What’s Involved?

As we’ve discussed, one of the more popular uses of a self-directed IRA is to invest directly in real estate — leveraging the longer-term nature and possible tax advantages of a retirement account to invest in an asset class that has traditionally performed well over longer timeframes but is not generally available as an IRA investment.

But it is important to know before you begin this process that investing directly in a piece of real estate through a self-directed IRA will require a lot of work. It will require, for example, all the work associated with any investment in a piece of real estate — researching the area, determining the ongoing expenses and income potential, finding and hiring the right professionals (property managers, landscapers, etc.) and possibly vetting tenants.

Moreover, because this investment will be handled through your self-directed IRA, you will also need to research the possible regulatory limitations and tax implications of any real estate deal.

For example, you cannot personally take advantage of any IRA investments until you retire and qualify for distributions. This would include, as previously discussed, using a self-directed IRA to purchase a property and then living in it or renting it to a business in which you have a majority stake. Because these transactions are not allowed, they can negate any tax benefits you might otherwise realize from the investment and might even lead to fines or penalties.

In other words, before you use your self-directed IRA account to invest directly in a piece of real estate, you will want to conduct a lot of research and perhaps seek the advice of real estate and/or finance professionals.

Investing a Self-Directed IRA in Real Estate Crowdfunding Deals

There is a way, however, to invest in real estate through your self-directed IRA that is more direct than simply purchasing shares of a publicly traded real estate company, but that requires no active management of the real estate on your part. That vehicle is the online, income-oriented real estate investment trust, called MogulREIT I, offered through the RealtyMogul.com crowdfunding platform.

As of 2017, the online MogulREIT I is now accepting retirement funds from self-directed IRAs. This means investors can now gain exposure to commercial real estate and enjoy potential benefits of passive income in their retirement accounts. Additionally, in a move that can be particularly useful for the longer-term nature of investments made through self-directed IRAs, MogulREIT is now allowing investors to automatically reinvest their dividends, thereby offering the possibility for compounded returns over time. Keep in mind there are risks to investing in the MogulREIT so it’s important to review the full offering documents.

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