Q: I am interested in learning more about investing in real estate in a self directed 401(k) or IRA. Can you offer a good resource or explain some of the advantages and disadvantages?
A: There are numerous third-party companies, particularly in the Western and Southwestern U.S.,Â that help investors take their IRA cash and use it to purchase investment real estate. The person who helps you do this is called an “IRA Custodian,” and he or she takes a fee for their efforts.
More people are starting to use their self-directed IRA cash to purchase property. And it is unclear whether or not the IRS considers this an inappropriate use of your IRA.
In the examples provided in Publication 590 “Traditional IRAs,” you are prohibited from borrowing money from your IRA,Â selling property to it, receiving unreasonable compensation for managing it, using your IRA as security for a loan, and buying property for personal use (present or future) with IRA funds.
IRA custodians argue that nothing in this specifically prohibits anyone from using IRA funds to purchase investment property as long as you use cash to purchase the property outright. In other words, you couldn’t use $10,000 from your IRA to purchase a piece of investment property and finance the rest.
To find out more, simply go to Google.com and type in “use IRA cash to invest in real estate.” About 70,000 links will come up, including some to IRA Custodians who specialize in this type of investment.
I know that real estate has been going gangbusters for the past few years and if you owned a home, it probably went up in value.
But investment real estate has at least as many headaches as owning your own home. You have to find tenants, or improve the property and sell it. Or perhaps you just have to maintain it. While there are people and companies who will do all of this for you, it will eat away at your profit and the investment may not amount to much when you’e all done.
Also, real estate is not exactly a liquid investment. It would take time to find a buyer if you needed the cash and wanted to sell.
The real question you have to ask yourself is not whether or not the IRS permits this sort of transaction, but whether it’s right for you. And, you have to wonder, will you do better owning and managing investment property than if you took the cash in your IRA and stuck it in an S&P 500 index fund?
The stock market has returned an average of 10 percent per year over the past 70 years. Real estate typically appreciates at a rate 3 to 5 percent per year. For years, real estate was a portion of a portfolio, not the whole thing.
For most Americans, purchasing property with IRA funds will eat up all of their cash. That’s hardly what you’d call a diversified portfolio (where you invest in a number of different types of assets so that you can weather any investment climate, from a 3-year bear market to the real estate crash of the late 1980s and early 1990s.)
Most investment advisors recommend you have no more than 50 percent of your total assets in real estate, and that includes your primary residence and a vacation home, if you own one. Taking a large chunk of cash from your IRA and moving it from an investment in the stock market to an investment property is risky. You might want to run some numbers with a financial advisor first.
That said, it could be a great move. As with any investment, please take the time to thoroughly investigate the process, the IRA Custodian, and his or her company before you sign any documents. If you don’t understand the documentation, ask an attorney to review it. Check out the company with the Better Business Bureau, your state’s Attorney General’s office and make sure they’re licensed to help you, if that’s required in your state.