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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.
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.
- 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.
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Is it worth the hassle?
Well, who is ready to buy their next home through a self-directed IRA?
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.”
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]
Interested in learning more about crowdfunded real estate investing? Check out these posts:
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?
28 thoughts on “Using Your IRA for Real Estate & Crowdfunding Investments”
My understanding is that if you have a solo 401K YOU are the custodian and UBIT doesnt factor into play. I am thinking of getting a self directed solo 401K for hard money loans. I was told you can have a self directed umbrella solo 401k and in it sub accounts-one directly at Vanguard and the other for real estate and hard money loans.
Anyone BTDT?
Check with your tax attorney or CPA. If you are investing in a LLC, I think you will find that UBIT does apply even in a Solo 401k.
And if the new tax bills pass this year, the LLC investments may also be problematic.
I think you will find that it’s virtually impossible to avoid UBIT in a retirment account., but let us know what you hear.
I have used a self-directed IRA for multiple rental properties. But I do not have any leverage so I don’t have to worry about the UBIT. For me to invest in anymore, I would have to take on some debt, but that starts to feel like work to have to worry about that.
I considered using it for the crowdsourced real estate, but I would be nervous if somehow that required the UBIT.
Also (at least my custodian) requires that I give a year end value for all of my holdings in the IRA. Easy enough for real estate, my agent is happy to do it for me. But it would be difficult to know how to report the value of a share in a condo, or in a crowdsourced development that isn’t even completed.
A self-directed IRA used for real estate investment, may or may not, eliminate the K-1 issue. If the underlying limited partnership uses leverage, a correctly prepared K-1 will report the amount UBIT due by an IRA partner. It is true that UBIT and UDFI are overlooked by syndicators and their tax preparers. Prior to investing with a self-directed IRA, inquiry should be made about the impact of UBIT on ROI and whether the syndicator will provide the necessary info on the K-1. Using a Solo 401k to invest in real estate, as opposed to a self-directed IRA, can eliminate the UBIT/UDFI issue.
Info taken from: https://www.401kcheckbook.com/checkbook-control-retirement-compliance/self-directed-ubit-udfi-ubti/
Shouldn’t one of the advantages of investing through your IRA is ignoring all the K-1s you get from your crowdfunded investments, including if any come after the federal filing deadline?
For me, the ability to say have 20-25 different investments from within one wrapper, for diversifications, without having to deal with all the extra tax forms (or pay someone to do that), would seem to more than offset the initial hassle factor of setting up a self-directed IRA.
I haven’t done this yet. Though I might someday explore doing this with a ROTH.
That’s what I was thinking.
There’s the hassle of the setup and fees of a self-directed IRA, but doing so can potentially eliminate the hassle of dealing with a pile of K-1s and having to file state taxes all over the country.
Best,
-PoF
Thanks for the comment, B! You are correct, K1s are a hassle (to put it kindly). The reason I didn’t add that as a “Pro” is because almost 100% of our clients that own real estate in some fashion also use a good CPA. So K1s, don’t have a major hassle effect for the most part.
However, if you do file your own taxes, you know how annoying the K1s are. So in that case, yes, that would be a pro.
Thanks for the comment, B!
Investing in real estate online through your IRA makes sense if you are investing in a REIT, rather than investing directly in property or in an LLC that owns property. REIT dividends are taxable as ordinary income and since REITs can produce relatively high current income, there is a benefit to investing through your IRA. I agree with Chad that investing directly in property, or in an LLC that owns property, gets more complicated and is not very tax efficient.
CAPFUNDR is not currently offering any REIT investments so I feel I can say this objectively. We do have a fund that invests in discounted, illiquid REIT shares, but this fund is now closed to investment. Some investors (including myself) invested in this REIT fund through their IRA. The process was a little more complicated as it required setting up a self-directed IRA with Pensco Trust, the custodian that we work with. Pensco also allows you to invest directly in real estate, if that is what you want to do.
Thank you for the input, Mitch.
It is clear that investment selection is key within a self-directed IRA.
Cheers!
-PoF
Hi Mitch, thanks for the comment! Always nice to have a true expert and industry leader weigh-in.
The custodians for the self-directed IRA seemed to be one of the hardest aspects to evaluate when I was researching. They are getting better with transparency, but it was still tough to find all the details you need to make an informed decision from just a fee perspective. And then, of course, the investments that they allow is also going to be vital.
Thanks again for the comment! Congrats on the success of CAPFUNDR as well!
Thanks Chad. Unfortunately the process of setting up the self-directed IRA can be a little cumbersome. The good news is that once you have it set up it’s pretty easy to make investments in real estate or other alternative assets. We work with Pensco but we’ve also had investors who invested through other custodians such as Millenium Trust.
Good post.
I’ve considered doing a Self-directed IRA for crowdfunded real estate as I did for Peer to Peer Loans. In the end, I decided if I was going to do that, the best way was a checkbook IRA, where basically you start an LLC, open a checking account for it, and all purchases come out of that account and all income from the real estate goes back into that account. Then the self-directed IRA owns the LLC.
The hassle factor, however, is very real, particularly the UBIT issue but also the loss of the benefits of depreciation on equity investments. So for me, really only worth it for debt investments/hard money loans and not the equity purchases. For now I’m just buying debt investments in taxable. Not very tax-efficient, but minimal hassle. I’ve already got the asset protection because all of the individual investments are their own LLC.
The hassle factor is real, indeed.
Can you elaborate on what you mean by the individual investments each being their own LLC? Is that something you set up or the nature of the investments?
Best,
-PoF
Thanks for the comment WCI! You sound well-versed on the topic, are you familiar with personal finance? Just kidding!
I agree with both of your paragraphs, and you have excellent points throughout. The LLC is the route to take, and I am still shocked by how many don’t use an LLC to own their rental real estate from an asset protection standpoint. We have this conversation a lot, many of our clients own rental properties in and around Philly in their own name.
Thanks, WCI!
I own a couple of very tiny rental houses in a self directed IRA and have been very happy with it thus far. There is no debt associated with them, so no UBIT. Of course, all the rents go straight back into the IRA, but that would be true of any investment returns in a retirement account. I consider this a very simple investment that I can understand…two small properties bought low with good rental returns. I’m not banking on a boom of appreciation to make the investment solid (although, would not frown on that!). I figure that, at worst, if we have another housing bust, the paper value of the houses will go down and maybe the rents will go down, but there will always be a rental market for these modest houses.
I’ve seen the buzz about real estate crowd funding and have had a little interest, too, but it seems more complicated and risky than I can tolerate. I might dabble at some point with a small amount of after tax money.
I’m going to borrow an idea from MMM here (from his recent post about 2016 spending). One other thing I think I probably gain out of this investment is that the purchasing, fixing up and minor bit of management involved satisfies a purchasing urge that might be directed elsewhere. This acknowledgement may strike many FIRE types as absurd, but there it is. 🙂
As I type this, I am making an offer on a third house on the same street. This one will be a regular, after tax rental with a small mortgage. The price to rent ratio in the area is still good, but prices are rising rapidly. I don’t live in the area anymore, but have a solid team already in place. It would be very difficult to find good value for rentals in my current location.
I’m happy to hear it’s working out well for you, Dr. NF.
Interesting thought on satisfying a purchasing urge with the rentals. I can see how that makes some sense. It’s nice to buy something that builds equity and generates income.
Cheers!
-PoF
Thanks for the comment, Dr. NightFIRE! It sounds like you have a wonderful process in place, understand the pros/cons, and are diligent with your search. Love it!
I hope you have a 3rd home to add to your rental portfolio. Thanks again for the comment!
A couple of notes:
-If the sponsor is incurring debt (e.g. taking out mortgages) on the crowdfunding real estate investment property, your IRA must pay a nasty tax called “UBIT” (Unrelated Business Income Tax). The tax is charged at trust rates, which means all UBIT income over about $12,000/annum is taxed at the 39.6% maximum rate (plus your State tax). During the operational phase of the investment, profits may be largely sheltered by depreciation, so no tax is due. But then, when the investment is liquidated, the proportion of the entire gain, plus recaptured depreciation, that was funded by debt is taxed at this confiscatory rate. BEWARE!! (My guess is that many crowdfunding sponsors are not fully aware of this issue.)
-Funding real estate notes in a self-directed IRA is only slightly more complicated than funding them with non-qualified money. And, since you pay tax on interest income at your ordinary tax rate, you’re not paying a tax penalty for using an IRA.
Thanks for the tip on UBIT. I am curious to know which of the crowdfunded platforms’ returns might be subject to the tax.
Best,
-PoF
Thanks for the notes, UAPhil! The UBIT topic is significant and beyond the scope of this “simple” to understand post. That is a subject that we like to bombard our client’s CPA with, a good way to see how efficient a CPA is right away!
Thanks!
Since Mrs. Freaky Frugal and I FIREd, I’ve really been pursuing the KISS principle. Even in real estate. We sold our home and downsized into a downtown apartment. My only exposure to real estate is Vanguard’s REIT fund.
The whole real estate crowdfunding trend seems too untested and risky to me. Maybe I’m being overly conservative, but it makes it easier to sleep at night. 🙂
Thanks, Mr. Freaky Frugal! Since you and Mrs. Freaky Frugal are FIRE’d, I think it is safe to say, “if it ain’t broke, don’t fix it!”
Cheers to KISS and being able to sleep at night! On a side note, it is nice to see a fellow Philadelphian commenting.
Thanks, Mr. Freaky Frugal!
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Seems troublesome much like a non-traded REIT (I am publishing a post on this in a few weeks). If you want physical real estate then buy a property. You can still leverage you money easily enough. Otherwise stick with traded REITs like the one you mention above. KISS is a great band and rule!
Thanks for the comment, Dads Dollars Debts! One thing you can’t make a mistake on is KISS (the band). From a personal perspective (no advisor hat on), I agree with your thought process with physical real estate and REITs. Non-traded REITs are their own bundle of headaches.
Thanks!
I appreciate your honesty with the pros and cons, especially the disclaimer at the outset:
“In my opinion, using a self-directed IRA for real estate is making your investment life overly complicated.”
I’m always exploring ways to make my investments simple and diversified, but it seems this one misses the former criterion. Thanks, Chad, I always learn something new over here at PoF!
Dr. C
Thanks, Dr. C! I pull a page from the MD playbook when walking through the pros and cons of any decision. I like to say, “I can diagnose and prescribe medication, but at the end of the day, you are still responsible for taking the prescription.”
There are many that like the “exotic” investments and this could be a great fit, but at the same time, I think too many overcomplicate their investments. I blame the hospital cafeteria for this virus of complicated investments (j/k!).
Thanks again, Dr. C!
As I’ve gotten deeper into crowdfunding real estate investing and seen promising returns, I absolutely have thought of using my IRA. Finding out the details was always on my list of “things to look up” so this very helpful. This just may help push me in that direction. Thanks Chad & PoF.
Thanks, Passive Income MD! I am glad I could help limit the “to-do” list by a small fraction. That is a win in my book. Thanks for the comment, and all the great content you deliver as well!