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Q: A real estate lawyer in another state suggested that I open a self-directed IRA and then purchase a rental income property inside it. But I’ve been unable to find a financial analyst or a tax person in my state to help. Nobody in my area seems to have much knowledge about this strategy. Is it worth pursuing and buying real estate with an IRA?

A: We don’t recommend using a self-directed IRA for a real estate investment without doing some due diligence because there are a lot of rules and red tape around buying real estate in a self-directed IRA.

If you purchase property inside an IRA, you not only risk possibly reducing your ROI potential, but, you must also follow IRS guidelines carefully when you spend the IRA assets. All the property’s maintenance, repairs and property taxes have to be paid from the IRA. In essence, you do not own the property – the IRA does, so any money in or out goes through the IRA. While it is advantageous to not have to pay for these expenses out of your own pocket, you also reduce the account balance in the IRA that could be growing tax-free.

If you generate profits – for example, if the house grows in value and you earn rental income – those profits will be taxed as ordinary income because they’re inside an IRA. You lose the tax benefits of real estate ownership that are otherwise available to taxpayers, including depreciation and amortization, as well as capital gains treatment on your profits. Since you used cash out of the IRA to pay for the property, you won’t have mortgage interest to potentially deduct on your taxes either. And don’t forget, property can be an illiquid asset if you need to sell quickly.

The withdrawal rules are still in effect if you’re buying real estate with an IRA or holding it with a broker. Because it’s an IRA, you must begin to make annual withdrawals starting at age 72. A house isn’t a liquid asset. You can’t sell just part of it to meet this requirement. It can be risky to meet this requirement if you don’t have reliable rental income. So be thinking about how you will generate the cash you need within the IRA to take the required withdrawal.

Unlike traditional retirement accounts, self-directed IRAs require that you hire a custodian. They typically charge a percentage of the account as an annual fee, but they cannot offer you any advice. They’re strictly there to handle the paperwork.

Another significant restriction is that the real estate property you invest in cannot be used as a second home, vacation home or for any other purpose than an investment. The IRS can disqualify it if you or immediate family members – like children, a spouse, grandparents, etc. – use the property.

If you can accept the restrictions around buying real estate with an IRA, you might be thinking this is still something you’d like to pursue. Real estate as a hard asset can provide diversification within your wealth management portfolio. Real estate can be a good long-term investment and can be a valuable asset. We, too, support the idea of a “long game” financial decision. Additionally, if you find stable renters, you can create a steady stream of income that can grow tax-free in your self-directed IRA.

When it comes to the pros and cons of using a self-directed IRA for a real estate investment, we believe the cons can outweigh the pros. Having more diversity in your portfolio is generally a solid idea. A financial planner can tell you more.