Real Estate Investing in an IRA
Self-Directed IRAs allow for a myriad of non-traditional investment vehicles such as gold, silver, and precious metals, as well as real estate, tax liens. However, if you are hoping to use a self-directed IRA for a home purchase, you are out of luck. However, with the exception of a handful of prohibitions like this, almost anything can be purchased within the framework of a Self-Directed IRA.
The most common alternative investment in a Self-Directed IRA is real estate. Buying a rental property inside of a Self-Directed IRA shields income from taxes. For example, all the rent payments are tax-free.
With the median home price in the U.S. around $187,000 as of January 2009, and the average rent around $1,370 per month, one can see how it is possible to earn almost ten percent return per year tax-deferred, plus any appreciation in the property value. When the property is sold for a profit, any capital gains tax is deferred as well. All without the complexity of a 1031 Exchange.
Another popular real estate investment for Self-Directed IRAs is discount paper. Discount paper, also known as private mortgages, usually carries high rates of interest for relatively short periods of time. Discount paper is also secured by real property. If an investor doesn’t have the IRA funds necessary to purchase a property outright, discount paper is a great place to start.
Property sellers will sometimes offer to carry a second mortgages to qualified buyers who can’t afford the entire purchase price of a property. The sellers can then to sell the second mortgage for cash. What they are selling is a stream of cash flow, usually at interest rates well above current mortgage rates, for a discount to the face value of the second mortgage.
For example, Hank the Homeowner may have acquired a $20,000 second mortgage paying ten percent interest for ten years when he sold his house, and now he wants to cash out that mortgage. He could sell it for $16,000 or $17,000 to have the cash in hand now, and the investor who buys the paper from him will receive $11,716 in interest payments in addition to the $20,000 return of principal over the ten year life of the loan. If the investor buys that paper inside a Self-Directed IRA, then almost 100% return will be tax-deferred as well.
Private equity is another potentially lucrative avenue of Self-Directed IRA investing. Providing bridge financing or start-up capital to private companies can lead to explosive growth. It can also provide an investor with much more control over his investment than a traditional investment in publicly traded stock.
Investors must be aware of the restrictions within a Self-Directed IRA as well. Prohibited investments include life insurance products and most collectibles, such as stamps and baseball cards. Also, the related party transaction prohibition outlines who may and who may not benefit directly from an investment originating in a Self-Directed IRA.
The IRA holder, their spouse, their children, grandchildren, and parents are all considered related parties. Therefore, the IRA holder may not purchase a home to live in with funds from his IRA, nor may he invest in his own businsses or start-up with IRA funds. The penalties for doing so include being taxed on the proceeds and paying a ten percent penalty in addition to the tax.