Self-Directed IRAs: Pros and Cons for Private Real Estate Investment

Private equity real estate is a long-term investment that offers investors price appreciation, passive income streams and tax breaks—and acts as a hedge against the volatility of stocks. It’s hard to beat this winning and remunerative combination of paybacks. Yet most people earn the nest egg they need for long term only one way—in their retirement accounts—which are often limited to publicly traded mutual funds, ETFs, stocks and bonds.

Real estate can offer better total returns long-term and preserve wealth in a volatile economy. Research shows that adding this asset class to a portfolio can generate the best risk-adjusted returns. Yet working Americans usually have little say over their retirement account investments because they are managed by custodians, such as brokerages and banks, that offer a set range of mainstream, market-based choices. And in many cases, funding decisions can be entirely out of investors’ reach and totally dictated by the custodian.

A self-directed Individual Retirement Account (IRA) lets investors expand on the typical choices to include anything from annuities to private equity to Bitcoin, which are all considered alternative investments. “At a traditional custodian, you have to pick from a menu of conventional investments. But if you know real estate, why wouldn’t you want to capitalize on an investment you believe in with a real estate IRA? Why be limited to ETFs and stocks that may or may not perform well long-term?” asks Daniel Hanlon, senior vice president of Midland Trust, a custodian that offers self-directed IRA accounts.

Solo business owners without employees qualify for self-directed 401(k) plans, which have many of the same pros and cons. A self-directed IRA is the more common option, but both require investors to do their homework. Here’s a starting point to evaluate the pros and cons of a self-directed IRA, and how to start one:

Pros: Diversification, Appreciation, Account Options (Traditional or Roth IRA)

• Diversification is the biggest benefit of a self-directed IRA. It gives a retirement account a range of alternative investment choices—not only real estate, but also private equity of every kind, precious metals, oil or gas projects, joint ventures, equipment leases, even tax lien certificates. All these choices offer the possibility of higher returns. Even some high-risk alternatives might be worth considering in an investment held for decades.
• As a less volatile investment that’s held for years, real estate is a logical investment for self-directed IRAs. Andrew Carnegie may have been only guessing that 90% of all millionaires get that way through owning real estate. Still, many millionaires’ portfolios have substantial property holdings. But other real estate related assets are also eligible for self-directed IRA accounts, including joint ventures or real estate debt.
• Both traditional and Roth IRAs can be self-directed. In a traditional IRA, investments are made tax-free, but the principal is taxed on withdrawal at retirement—a good choice if the priority is keeping the cash now. Roth IRA assets have already been taxed, and all returns are tax-free. Either method avoids capital gains on the sale of assets within the IRA, which over the years can be considerable.

Cons: Investment Limits, Tax Implications, Other Risks

• The tax code gives a self-directed IRA more options than a pension or 401(k) plan, but there are limits. Like other retirement accounts, they cannot invest in collectibles like coins or artwork, for which future prices are speculative and uncertain. And not all real estate is an eligible IRA investment. Your home or a vacation property you use regularly can’t be held in your IRA, even if you pay yourself rent. However, a rental property or other asset could be pulled out of an IRA once you retire to become your own residence.
• Real estate may have immediate tax advantages if held outright that may outweigh the benefits of keeping it in a retirement account. Private equity real estate offers a depreciation shield for capital gains that provides more immediate benefit to an income portfolio than an IRA. Qualified Opportunity Zone fund investments in an IRA lose the tax credits and deferrals that make them attractive to many income investors.
• Assets bought on borrowed money generate what the IRS calls unrelated debt-financed income (UDFI). Investors are taxed on revenue derived from the loan, based on the loan-to-value ratio. Expenses, depreciation and other deductions will reduce the tax liability. But even with the UDFI tax, a leveraged investment will generally produce a higher return than an investment of the same principal in an unlevered investment vehicle. For example, a private equity real estate investment that provides a pre-tax multiple of 2.5 times its acquisition price may have an after-UDFI tax multiple of 2.1x. The return is still double the original investment. An investor will face tax consequences from any leveraged property, so those who use leverage must weigh whether the expected returns and diversification outweigh the tax consequences before putting it in a self-directed IRA.
• Not all alternative investments are suitable for a retirement account, especially for people nearing retirement age. Bitcoin and other cryptocurrencies are a potential self-directed IRA choice, for example, but not necessarily a good one. The U.S. Securities and Exchange Commission warns Initial Coin Offering (ICO) investors about the potential for fraud. Promotors might misrepresent not only the digital assets themselves but also the self-directed IRA custodian, which has no role in investment performance.

Next: Finding a Trustworthy IRA Custodian

Once an investor has weighed the pros and cons and finds value in the self-directed approach, there’s one more hurdle to overcome. A self-directed IRA custodian—or for a sole proprietor, a self-directed 401(k) intermediary—can be hard to come by. Few banks offer self-directed accounts, and the IRS short list of nonbank trustees does not indicate their range of experience or mention fees.

Fees vary by custodian. Some may charge a bit more for the added flexibility of a self-directed account, and others may offer fee discounts that can range up to 5% or more based on relationships with fund managers, says Hanlon. Accounts can carry flat fees, or charge based on individual transactions or distributions, on top of whatever commissions or fees are involved in any investment, Hanlon adds.

In vetting custodians, look for an established track record as trustee and investigate the organization’s staffing and fee structure. Once an investor is comfortable with the custodian and how it operates, setting up the account takes only a few minutes, Hanlon notes.

Finally, diversifying a portfolio is not a hands-off process. Self-directed IRA custodians do not evaluate the legitimacy or quality of an investment. It’s the shareholder’s responsibility to study purchases, asset managers and other trusted partners with the same level of care. Starting a self-directed IRA is only the beginning of a due diligence process, but one that can yield bigger dividends and a larger nest egg in decades to come.