Using Your IRA for Real Estate & Crowdfunding Investments
Today’s guest post was written at my request by Chad Chubb, CFP of Wealthkeel. I am intrigued by the substantial returns being offered in the crowdfunded real estate space, but less enthused about the tax treatment of those returns, particularly while occupying the top tax brackets.
Knowing that real estate can be owned in a self-directed IRA, I figured why not crowdfunded real estate investments?
What follows is the result of my inquiry. I want to thank Mr. Chubb for the time he took to research the topic and write this informative article. His company, Wealthkeel, is an advertiser on this site, but this is not a sponsored post.
Using Your IRA for Real Estate & Crowdfunding Investments
Our story starts here, “Hey Chad, I heard that I can use my IRA to buy real estate. What do I need to do?” The good news is it is possible, the bad news is it can get complicated and expensive in a hurry. This topic comes up more often than you would think, more out of curiosity than anything. Usually, the question is in regards to physical real estate and buying rental properties, but the real estate crowdfunding question does come up now and then.
Please keep in mind that for both the physical real estate and crowdfunding real estate, we are assuming you are using a self-directed IRA for the transaction. This route adds more complexity and steps compared to buying property with cash (also known as non-qualified money). You don’t have to make investing overcomplicated!
Back in my hockey days, one of my favorite coaches would use the KISS acronym “keep it simple, stupid.” In my opinion, using a self-directed IRA for real estate is making your investment life overly complicated. So, if you were looking for a passion piece on why it’s the world’s best investment idea, you won’t find it in the proceeding paragraphs.
Pros and Cons of Owning Real Estate in an IRA
Okay, let’s get started! The first step is to have an IRA or Roth IRA already established. Your next step would be to then move it to a custodian that would allow you to utilize physical real estate and/or crowdfunding real estate. This is called a “self-directed” IRA or Roth IRA.
Physical Real Estate
The best way to get this to work is with a LARGE IRA balance, you will see why shortly. On a self-directed IRA custodian’s website, they listed the following “pros” to real estate investing via a self-directed IRA.
Here is what they listed, followed by my rebuttal:
- Delayed taxes on investment gains.
Hate to be the bearer of bad news, but that happens no matter what is inside of an IRA or Roth IRA. In addition, with an IRA (not Roth IRA), if you sell the property for a gain you are paying ordinary income taxes opposed to the preferred capital gains rate.
- Tax-free growth through a Roth IRA.
Yes, you will get tax-free growth inside your Roth IRA, just like everyone else does. The bigger problem here is that many don’t have the Roth IRA account balance to invest in real estate.
- Leveraged growth.
The point they make here is that you only need “X” to buy “Y” since you can use debt to leverage the transaction. This is a good one in theory, but don’t forget the mortgage is NOT in your name. It is owned by your IRA in a non-recourse loan. Another step to add to the complexity.
- Protection against inflation and market volatility.
Market volatility is fair, but let’s not forget that a housing crisis did occur recently as many of you recall. No investment is safe from volatility, ask the Tulips in 1637 (aka Tulip Fever).
- Rental income.
This one takes the cake. What they forget to tell you is that all your proceeds would have to go back into your IRA until you hit age 59.5 to avoid a 10% penalty and you will still owe income tax on the account.
- A chance to pay for your dream retirement home.
Nothing like having your dream retirement home that you technically cannot live in yet! If your IRA owns the home, you can’t live in it based on current tax rules. Benefiting personally from any asset owned by your IRA is prohibited by the IRS (self-dealing). “We’ll let the kids live there for now.” False! No lineal relatives can live there. This would include your parents, grandparents, children, grandchildren, spouse, and fiduciaries. And don’t try to get fancy with “rent” or “vacationing,” not allowed!
I think the list of “pros” above are very limited to say the least, but here are some other “cons” to keep an eye on.
- Many of your tax advantages would be wasted by using real estate inside of an IRA. You wouldn’t be able to deduct interest, you lose depreciation, and if you sell the property, the proceeds go into your IRA and will be taxed as ordinary income. If this transaction is completed outside of an IRA, you would pay the lower capital gains rate. In defense of the self-directed Roth IRA, you could avoid taxation there since you already paid Uncle Sam.
- One wrong move could lead to your IRA being disqualified and create a fully taxable distribution.
- Any money for improvements, maintenance, insurance, and taxes on the property also need to come from your IRA. You would need to keep A LOT of cash on hand. You can only add $5,500 per year to an IRA, so if money is tight, it could lead to bigger issues. I know you watch HGTV, how often does their “original” budget match their final budget? Never.
- If that isn’t enough, the self-directed IRA custodians usually have high fees and a potential fraud risk.
Is it worth the hassle?
Real estate is an excellent asset class, and the point I want to make is the added work and complexity of buying real estate through an IRA. If you like the idea of owning real estate and being a landlord, do it the right way, save up money for your down payment and buy the home with cash and a mortgage.
Don’t add the headaches of having your IRA own it. Also, if you want to be a real estate mogul make sure you set up an LLC for asset protection and to hold your “risky” assets. It is similar to a REIT (Real Estate Investment Trust) platform, although, they are different for many reasons.
Crowdfunding Real Estate in an IRA
We are looking at this option through the self-directed IRA lens, not investing cash. Investing cash is a much simpler route, and should be the primary course for most. Quick detour, here is a good history of the real estate crowdfunding movement. It is fair to say that this is the easier route if you wanted to use a self-directed IRA to buy real estate.
If you are going to use an IRA for this transaction, you still need to have a custodian that allows this type of investment. For example, RealtyShares shows their approved custodians here. Some custodians require a $10,000 minimum IRA investment with a few custodians as high as $50,000.
Liquidity is an issue with these funds. Here is a direct quote from RealtyShares, “These hold periods vary by investment, and can vary from less than 6 months to greater than 5 years; they are also estimates only, and actual hold periods may be longer or shorter than the periods initially projected.”
FundRise notes quarterly redemptions on their site. For most, that should not be a huge issue since you’re investing for the long-term (hopefully) with their IRA/Roth IRA. However, anything that limits liquidity is a concern, especially when they say “5 years or greater.”
Using a self-directed IRA does have the benefit of not having to pay taxes in numerous states, which is usually a downside to crowdfunding real estate since you don’t have control of where the transactions are occurring.
My leading fear to the crowdfunding real estate play is the unknown, and by unknown, I mean what happens during the next housing crisis? FundRise was founded in 2012, and RealtyShares was founded in 2013. Rather convenient timing considering the housing market has been relatively steady since that time.
My goal is not to scare you from real estate, but I wanted to share some of the pitfalls that come with self-directed IRAs and real estate. You don’t need to make investing overly complicated, and a self-directed IRA is going to require extra homework with the possibility of turning into a disaster with one wrong move.
Last but not least, all real estate investing requires the proper due diligence. Whether you are investing in a crowdfunding site, and/or physical rental properties, always do your homework. Remember, “KISS!”
Disclosures to keep my compliance team happy:
– For ANY tax and/or legal notes above, I am not an accountant/CPA or an attorney. Please be sure to consult an accountant/CPA or an attorney before implementing. This blog does not constitute tax advice or legal advice.
– Registered Representative offering securities through Cetera Advisor Networks LLC, member FINRA/SIPC. Cetera is under separate ownership from any other named entity. Neither Cetera Advisor Networks LLC nor any of its agents provide tax or legal advice. Advisory Services and Financial Planning offered through Vicus Capital, Inc., a Federally Registered Investment Advisor.
– REITs are subject to various risks such as illiquidity and property devaluations based on adverse economic and real estate market conditions and may not be suitable for all investors. A prospectus that discloses all risks, fees and expenses may be obtained from Chad [717-443-1759]. Read the prospectus carefully before investing. This is not a solicitation or offering which can only be made in conjunction with a copy of the prospectus.
[PoF: While I can see why owning physical real estate may not make a whole lot of sense in a self directed IRA, I continue to be intrigued by the possibility of holding crowdfunded real estate investments in a self-directed Roth IRA They have shown promising returns.
Using a traditional IRA would take away my ability to do annual backdoor Roth contributions without paying taxes, so I would only consider a Roth option.
Currently, I have about 8% of my money in Vanguard’s REIT index fund, and I could potentially sell some of that investment to invest in crowdfunded real estate in a self directed Roth]
What are your thoughts, readers? Do any of you use a self directed IRA? Would you consider opening one to make some of these tax inefficient crowdfunded investments? Care to talk me out of the idea?