In an era when retirement pensions are practically non-existent, tax-deferred Individual Retirement Arrangements (IRAs) provide workers with a way to save for their retirement years. But in today’s uncertain economy, individuals concerned by the stock market’s volatility can gain greater control over their retirement funds by opening a self-directed IRA (SDIRA). One of the advantages of an SDIRA is that it provides access to alternative investment opportunities, including income-producing real estate.
However, using an SDIRA to purchase rental properties can be complicated to those who are newcomers to the sector, which is why investors likely need to use a real estate IRA custodian to help them understand the tax code governing this type of investment and guide them through the investment process to avoid unexpected penalties and reap all of the available benefits.
To gain an understanding of how SDIRAs work when investing in real estate, NREI asked Meg O’Connor Zwick, a senior vice president and director of client services at Millennium Trust Company who specializes in directed-custodian services for IRA investments, to share her knowledge about this investment option. In the following Q&A, she explains how an SDIRA works, its advantages, challenges and unique rules that apply to investing IRA funds in in non-standardized, alternative investment like real estate.
This Q&A has been edited for length, style and clarity.
NREI: Please explain how an SDIRA works, and how it is different from an IRA managed by a third-party?
Meg O'Connor Zwick: Self-directed IRAs allow individual investors to make and direct their own investment decisions. One advantage is to be able to invest retirement savings in non-standardized, or “alternative” assets, such as real estate, private equity, private stock and hedge funds.
Self-directed IRAs offer the same tax benefits as regular IRA accounts, allowing investors to place retirement funds into traditional investments, such as stocks, bonds, exchange-traded funds (ETFs) and alternative investments that are not typically supported by standard brokerage firms—often due to administrative complexity.
NREI: At this time, why might real estate be a smarter investment for an SDIRA investor than stocks or other investment choices?
Meg O'Connor Zwick: Successful investing is generally based on diversification and risk mitigation. Real estate has the potential to offer a non-correlated investment return to a portfolio of stocks, bonds and ETFs. Traditional equity markets have shown to have a fairly high correlation between small-cap, mid-cap and large-cap stocks. It is becoming more challenging to find diversification in today’s equity markets, even between different market-weighted indices, so real estate may be the right choice for a given investor.
NREI: What are the challenges, risks or pitfalls involved in investing in real estate through an SDIRA?
Meg O'Connor Zwick: Investors generally have to have knowledge about the investment that they are making and feel comfortable with having some [potentially] limited liquidity. A financial advisor and tax advisor can help the investor understand the implications and IRS rules for the investments in their portfolio, and an experienced custodian can help to ensure everything in the IRA is properly titled and in compliance with IRS reporting regulations.
NREI: Are tax incentives and rules for deferring taxes different for investing an SDIRA in real estate than investing in other investment options? Please explain incentives and rules that apply to real estate that may be unique.
Meg O'Connor Zwick: The tax structure and rules for investing in real estate through an LLC or fund structure are similar to other SDIRA investment types. If a client would like to purchase a specific property directly, there are some additional rules that the investor needs to follow. Taxes and maintenance on the property, for example, must be paid out of the self-directed IRA to avoid the IRS-prohibited transaction rules.
NREI: Are returns on investment (ROI) in real estate tax-deferred if reinvested in more real estate or capital improvements to the property or how does this work? Are there any special IRS rules that must be followed for reinvestment or capital improvements?
Meg O'Connor Zwick: All returns within a self-directed IRA are tax-deferred since they stay in the IRA. Income or appreciation generated by the investment must stay in the IRA, but can be used for capital improvements. Tax implications come into play when distribution of income or an asset occurs.
NREI: What are sequential steps advised for completing an SDIRA real estate deal?
Meg O'Connor Zwick: If the investment is within an LLC structure or fund structure, most custodians will ask to review the offering documents to make sure the investment is operationally feasible to be held in an IRA. If investing in a direct piece of real estate, investors reach out to their preferred IRA custodian to learn more about what is needed for this transaction type.
NREI: What types of advisors are recommended for the SDIRA investor?
Meg O'Connor Zwick: An existing advisor that oversees a client’s assets may not have the ability to purchase non-standardized assets. Purchasing a non-standardized asset, such as real estate, with IRA funds is generally completed with the help of a custodian like Millennium Trust, which specializes in the custody of non-standardized, or “alternative” assets.
NREI: Are there other reasons an SDIRA investor who wants to invest in real estate should seek the services of a custodian that specializes in managing investments in alternative assets?
Meg O'Connor Zwick: Many advisors are unaware that investors can hold alternative investments in a self-directed IRA. Advisors should educate themselves and their clients on these types of assets to better serve their clients’ needs and work with a custodian that will help them meet regulatory standards and high client expectations.
NREI: Is there any additional advice you have for SDIRA investors?
Meg O'Connor Zwick: Investors that open up self-directed IRAs often have a specific investment that they would like to gain access to with tax-deferred dollars. Self-directed IRAs provide investors investment opportunities that are not possible within a traditional brokerage/IRA structure.