My wife and I both own rental properties in our Individual Retirement Account (IRA), and let me tell you how satisfying it is knowing that the government will never touch the rent we deposit back into our accounts each month from those properties.

The majority of people who work contribute regularly to a 401(k) or an IRA, but most don’t realize that the IRS allows them to invest those funds in anything they want (other than life insurance and collectables).

That means you can use your retirement funds to invest in the typical stocks and bonds, but also any other asset like businesses, real estate, cryptocurrency, farming, precious metals… you name it and you can probably invest in it (other than the two items specifically banned in the code, life insurance and collectables).

There are guidelines that must be followed in order to comply, but in so doing, a person can exponentially grow their nest egg totally tax free.

How Does a Self-Directed Retirement Account Work

Your typical retirement account is set up by a 401(k) provider or a bank, and offers a narrow set of mutual funds that an account holder can choose from.

The 401(k) providers are incentivized to only offer select mutual fund investments because there is typically some sort of management fee when you invest your money in one of their offerings.

So there is no incentive to inform someone that they have the ability to invest their retirement money however they want, simply by self directing their account.  As a result less than 2% of retirement savings is self-directed.

The other reason that you don’t typically see as many self-directed retirement accounts is because most working people use their retirement account as a very passive investment… they set it up and forget it.

With a self-directed IRA, the account owner plays a much more active involvement in deciding what to invest in.

So if you are the type of person who does not like to get involved with your investments and are comfortable with the returns a standard passive investment offers, there is no point self-directing your account.

It’s staggering, however, how quickly the returns on a solid rental property can far exceed a standard passive mutual fund investment when you start to consider the appreciation on the asset and the monthly cashflow from rent.

The annual limit on contributions into a Roth IRA is $5,500, which means it will be many years before a person can accumulate very much wealth in their account at a standard 8% return, but with the rehab of a low cost rental property, a person can boost the value of their IRA substantially through forced appreciation and watch it grow monthly with regular rent check deposits.

Guidelines To Follow

Disclaimer: I am not a certified tax professional.  This information is based on my experience and self study. Do not take any action solely based on my advice. Seek the counsel of certified legal and tax professional before making any changes to your account.

The fundamentals of investing in a real estate deal inside or outside of your retirement account are essentially the same.

A retirement account isn’t going to make a crappy deal a good one, it is just a label that is put on those funds so that the IRS cannot tax the returns.

There are several rules that a person needs to be aware of when self-directing and a good IRA custodian and CPA will help guide you in order to make sure you are not making any prohibited transactions.

These are some of the main guidelines that the IRS lays out when it comes to self-directing your investment and by making a small mental shift when it comes to the way you think about these funds, I have found, makes the process fairly simple.

1. Think about your retirement account as if it were a separate entity from you totally

There needs to be a defined distinction in your mind between the way your personal funds and assets are handled and how your self-directed retirement funds and assets are handled.

Think of your personal funds as something you control and spend as you please.  Think of your IRA funds and assets as owned and controlled by a separate entity completely (your IRA).  The two should never come into contact.

For example, if you are buying a rental property with your self-directed IRA, the name of your IRA is on the title as the owner.  Every cost associated with that property from the purchase to maintenance and taxes, must come out of your IRA.

Likewise, all the monthly rental income as well as the profit from a sale must go directly back into your IRA.  This money can never intermingle.

2. The retirement account can’t benefit you or your direct line family in anyway until retirement

The whole purpose of a retirement account is to be invested during your working years and enjoyed during your retirement years (the IRS defines retirement age as 59.5 years or older).

Therefore, you can’t purchase any investment that you or your family members can use or benefit from personally.

For example, you can’t buy short term vacation rental property and stay there a few weeks a year.  You can’t buy a rental property and rent it to your parents or brother.  You can’t give a loan to, or buy equity in, your son’s business.

As long as there is no way that you or a family member will benefit from the investment prior to withdrawing the funds from the retirement account after age 59.5, then the investment most likely is allowable.

3. You can’t actively work on the investment

Using your own sweat equity to increase the value of your investment is not allowed.

This means that you can’t buy a fixer upper and do all of the needed construction work yourself  regardless of whether you pay yourself for your time or not.

It is perfectly acceptable, however, to buy a fixer upper and pay contractors to do all of the work required, as long the contractor payments are coming from your IRA and not you personally.

Thinking about the intent behind these rules helps keep it all straight.  The idea is that an investment made in your retirement account needs to be owned by the account and stand on it’s own without the account holder’s interference, other than administrative tasks, like picking the investments and directing payments.

The consequences for violating these guidelines are that tax advantages of the IRA can become disallowed, which means that it is as if the account holder liquidates their IRA, thereby losing all tax advantages and incurring early withdrawal penalties.

The Argument Against Real Estate in Self-Directed IRA’s

When you own a piece of property outside of a retirement account, you get the personal tax advantage that comes from owning real estate.

The two major sources of tax write offs being your ability to depreciate the value of the property each year and write off any interest payments made throughout the year.

Most of the time the rental income is completely offset by these write offs, so it is not taxble anyway, and the capital gains on the sale of a property can be deferred through a 1031 delaying having to pay the taxes.

Therefore many people will argue against owning real estate inside an IRA because of the personal tax benefits you miss out on.

This argument makes a lot of sense for a lot of real estate.

However, there is a niche of low cost high cash-flowing real estate that I feel is ideal to own inside a self-directed IRA.

These are the properties that I mainly focus on, and due to the low cost, there isn’t much depreciation or interest expense to write off.  This means the high cashflow would be highly taxed outside of a self-directed IRA, but untouched inside an IRA.

Here is a link to an example project that is the type I target in the south suburbs of Chicago and feel is ideal for owning within an IRA.

How to Self-Direct Your Own Retirement Account

Self-directing your retirement account is not for everyone (actually probably not for most people), but is an incredible tool for those who enjoy more control over their funds and have invested in the knowledge to put the funds to work in something that has a high potential of beating a mutual fund return.

It’s actually incredibly simple to set up.  There are IRA Custodian companies that hold the funds in a self-directed IRA for you and deploy your funds however you direct (which keeps them from mingling with your personal funds).

The fees for a self-directed IRA custodians are typically very minimal and based either on the total amount in the account or on the number of transactions you do.

You can google Self-Directed IRA custodian and get a list of over a hundred that all essentially do the same thing.  My wife and I use Midland IRA to manage our accounts and their online platform allows us to direct the funds however we want, which we really like.

If you have a standard Roth or Tradition IRA already set up, you can simply notify the account holder that you will be transferring the funds to the custodian that you choose, and within a week the funds are transferred over and you can begin directing them however you want.

Most of the time you can’t self-direct your retirement savings account or 401(k) at your current job, but as soon as you change jobs, you can roll those funds into your self-directed IRA.

For more info on this, you can listen to this podcast episode where I share the details of one of my IRA real estate deals.

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