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Investing directly in real estate using a self-directed IRA is a popular way to diversify a portfolio and allow a real estate investment to appreciate in a tax-advantaged manner. Many of PENSCO’s savvy real estate clients—who prefer to remain in control of their real estate holdings—use their IRA to do just that.

But what does direct investing in real estate using a self-directed IRA entail? The process works differently than buying real estate with taxable dollars, and it can require more legwork on the part of the IRA owner. Below are the key elements investors should understand when directly investing in real estate with their retirement account:

1. The paperwork

The process usually begins after an IRA account owner finds a property, either on their own or through a broker/agent, that they want to purchase using retirement funds. When a purchase agreement is drawn up and an earnest money deposit is agreed upon, the name of the buyer must be listed as the name of the IRA, and the funds for the deposit MUST come from the IRA’s cash balance (NOT from the IRA owner’s personal checking account). 

For example, at PENSCO, the buyer name on all purchase agreements, escrow documents, and recorded documents would read “PENSCO Trust Co. Custodian FBO (client name) IRA.”

The account owner should then sign all purchase contract documents as “read and approved” and forward them to the IRA custodian for countersignature*. In addition, if there are addendums or amendments to the purchase contract or any other documents, the IRA must countersign for the account owner on those as well.

2. The deposit

The IRA account owner must then instruct their IRA custodian to send the earnest money deposit funds to the title/escrow company from the cash balance in their IRA. Prospective buyers cannot use personal funds for the down payment and then be reimbursed by the IRA. That would potentially be considered a prohibited transaction in the eyes of the IRS. However, if the IRA owner does not have all of the required cash available in a self-directed IRA, other financing options are available, such as a non-recourse bank loan.

3. The review

At this point, the self-directed IRA custodian can typically work with the title/escrow company to go through the remaining steps in the process because they will have contact with all parties involved**. The IRA custodian will need to review several other documents to make sure that the investment is administratively feasible, and the purchase would not entail a prohibited transaction. These documents include:

• A preliminary title report for the property (to verify that the seller is on the title, that the seller is not a disqualified person with respect to the self-directed IRA, and to see if there are any liens/encumbrances on the property)
• A proposed grant deed (showing that the buyer/owner is “(custodian name) Custodian FBO (client name) IRA” and the owner’s address belongs to the IRA custodian)
• Escrow instructions from the title/escrow company (initialed/signed as “read and approved” by the client)
• A final settlement statement (initialed/signed as “read and approved” by the client)
• Custodial forms (every IRA custodian will require one or more forms to complete the purchase)

The title/escrow company usually handles the recording of the grant deed (or applicable instrument) and then returns the original to the IRA custodian for safekeeping.

4. The management

After the self-directed IRA funds are in escrow, documents have been signed, and the grant deed has been sent for recording, the IRA takes ownership of the property, and the IRA account owner is free to rent, lease, hold, or sell the property.

If the IRA account owner chooses to rent or lease the property, most self-directed IRA custodians strongly encourage IRAs to appoint a third-party property manager to gather rental payments and forward them to the IRA. As with any income generated by a real estate investment owned within an IRA, all rental payments/income must be paid to the IRA and not to the underlying account owner personally. Rental income that is cashed by the account owner in their personal checking account may be construed as a distribution from the IRA and is subject to taxes and penalties.

Additionally, any improvements made to the property must be invoiced to and paid for by the IRA. Essentially, this means that the IRA account owner cannot make any improvements/repairs by themselves. Instead, they must hire outside parties to perform the work. The IRS typically views any improvements/repairs done by the owner to be “sweat equity,” and taking such actions may be considered a prohibited transaction.

In addition, the IRA account owner and any other of their disqualified persons are not allowed to use the investment property for personal use. For example, an IRA account owner cannot use an investment property owned by his or her IRA as a vacation home for themselves or their family.

Finally, any expenses such as utility bills and property taxes must be paid from the IRA. The county where the property is located should have the IRA custodian’s address as the address of record and mail property tax bills to them when taxes are due.

The decision

At the end of the day, the process of directly purchasing a piece of property in a self-directed IRA is similar to buying it outside of an IRA. The main difference is that all documents (after being initialed/signed by the account owner) must be countersigned by the IRA custodian, and the money for the purchase must come directly from the IRA.

Direct investing in real estate using a self-directed IRA requires more legwork and maintenance by the investor to avoid any prohibited transactions. However, it gives investors more freedom and control than other types of real estate investments.

Editor’s Note: This is an updated version of a post we originally published in August 2015. We welcome new comments and questions below.

*This is the general rule for all documents in this process.

**In some states, real estate investment transactions are handled by attorneys rather than title/escrow companies.

This Blog does not provide investment, tax, or legal advice nor does it evaluate, recommend or endorse any advisory firm or investment vehicle. Investments are not FDIC insured and are subject to risk, including the loss of principal.

Pacific Premier Trust (formerly PENSCO Trust Company) performs the duties of an independent custodian of assets for self-directed individual and business retirement accounts and does not provide investment advice, sell investments or offer any tax or legal advice. Clients or potential clients are advised to perform their own due diligence in choosing any investment opportunity as well as selecting any professional to assist them with an investment opportunity. Alternative investments are not FDIC insured and are subject to risk, including loss of principal. Pacific Premier Trust is not affiliated with any financial professional, investment, investment sponsor, or investment, tax or legal advisor.

NOT FDIC-INSURED | NO BANK GUARANTEE | MAY LOSE VALUE