By Allen Giese, CLU®, ChFC®, ChSNC®

If you’ve thought about buying real estate with your FRS money, this one’s for you.

One of the issues we see with retiring FRS Special Risk participants is if they want to buy real estate investment property in retirement. The problem is that for most of these retirees, their wealth is inside their FRS plan, whether it’s their DROP, deferred comp, or investment plan, and none of those plans allow the purchase of real estate property in the plan. And if you roll the money over to a traditional IRA, that doesn’t work either, since real estate is not allowed in your traditional IRA.

So, if you want to buy a piece of property, it would seem you need to take a big taxable distribution, pay potentially up to 37% in taxes to provide that cash, and nobody wants to do that.

In steps the self-directed IRA. But be careful! Let’s look at the pros and cons.

A self-directed IRA allows investors to hold alternative assets like real estate, private equity, or even precious metals in their retirement accounts—things not allowed in your traditional IRA. Transferring your funds from your FRS plan or traditional IRA to a self-directed IRA so you can invest in real estate has some advantages as well as some disadvantages. Let’s look at some of the advantages first.

Self-Directed IRA Advantages

Just like in your DROP, investment plan, deferred comp, or any IRA, investments grow tax-deferred in a self-directed IRA or tax-free in a Roth self-directed IRA. Nice advantage, but nothing unique here for the self-directed IRA because the same is true in your regular IRA and FRS plans.

However, a tax advantage a self-directed IRA has that is unique, because it allows you to hold real estate, is that when you sell an investment property that is inside the IRA, there is no capital gains tax due if you sell the property for more than you bought it for. That’s certainly attractive, especially if you buy property low and sell high.

Real estate historically has been a good hedge against stock market volatility. It’s not unusual for real estate to be holding its own and retaining its value even if the stock market is falling. So, if you have plenty of stock market investments elsewhere, adding real estate to your portfolio might be a good idea.

Plus, real estate has the potential to provide a nice, ongoing steady stream of rental income along with potential appreciation in the property. And when you decide to put real estate in your self-directed IRA, you have total control and flexibility as to what property you choose, whether it’s residential, commercial, land, or even real estate notes.

The Downside

So what’s the downside or things you need to make sure you’re aware of before you run to open your self-directed IRA and start putting real estate property in it?

For starters, there are some pretty strict IRS rules you need to follow and penalties you’ll pay if you go outside those rules and get caught. For one, you cannot personally benefit from the property. And that’s a big one. That means you can’t live in it, and you can’t use it for a vacation home.

Another important rule is that all expenses, including every repair, all real estate taxes, and any insurance, must be paid directly from the self-directed IRA. And all income from the property must go directly into the self-directed IRA.

You aren’t even technically allowed to do any work on the property yourself. You’re required to hire somebody to do every repair and enhancement to the property and pay whoever you hired out of the IRA. In other words, basically, you can’t touch it.

And I know what you’re thinking: “Who’s gonna know?” But when you realize how severe the penalties are if the IRS does find out, I’d ask you: Do you really want to make that kind of a gamble? Probably not.

So, this also means that you’ll probably need a fair amount of cash in the account, as well as the ability to write checks out of it, because you never know what you’ll be needing it for.

You also need to be very aware of what are called “prohibited transactions.” These are typically buying from or selling to yourself or a family member. So, let’s say you use $500,000 from your self-directed IRA to invest in a rental property and then let your son or daughter move in. Even if they pay rent, the whole thing would be considered a prohibited transaction. Once discovered, the IRS could rule the $500,000 you sunk into the property is a distribution, and you would be paying the subsequent income taxes and penalties. That would be a disaster.

Another potential drawback to consider is when you own real estate inside a self-directed IRA, you forgo the numerous tax breaks normally associated with owning real estate, like depreciation and interest write-offs.

So, if there’s a way to buy the property outside of an IRA, that could be more beneficial and certainly more flexible for you. But I realize that may not be an option, which is what this video is about because all your wealth is tied up inside tax-deferred plans. But hang in there—I do have an idea on how you can still get the benefits of real estate in those plans that I’ll tell you in a minute or two.

And finally, before you run to open a self-directed IRA, consider that self-directed IRAs typically have higher administrative and custodial fees compared to traditional IRAs and your FRS plans. They require a custodian to manage the IRA, which adds a new layer of costs. And there are definitely more record-keeping and compliance requirements you need to be aware of.

REITs

So what at first seems like a great idea, it’s not so simple, and we’ve seen more than a few jump in these waters without checking the depth first. A wrong move here and it could cost you a bundle.

One idea you might want to consider that is so easy it’s almost beautiful is just purchasing a real estate investment trust, or REIT, in your traditional IRA or FRS plan. Those are allowed, and they are offered.

You’ll get the diversification benefits of real estate, and the REIT already has professional management, so you won’t have to hire a management company to fix a problem as you probably would need to do in a self-directed IRA—because remember, in a self-directed IRA you can’t do any work on the property yourself.

Plus, REITs’ expenses are low. Really low. I very much doubt you could manage a property anywhere near as low a cost as the expense level some REITs will charge you.

And it’s easy. Ridiculously easy. A few clicks on your computer and real estate is now part of your portfolio.

Is a Self-Directed IRA Right for You?

So is a self-directed IRA a good idea? It depends on your investment strategy.

If you have experience in real estate, are comfortable navigating IRS regulations, want to spend a fair amount of time in retirement on a project, and have other sources of liquid retirement savings, a self-directed IRA can be a great tool—and maybe even fun!

However, the complexity and restrictions make it less appealing for more hands-off investors, and we’ve seen quite a few wishing they hadn’t gone in this direction. Look before you leap.

Would you like help evaluating whether a self-directed IRA is the right fit for your situation? Give us a call.

In the meantime, thanks for watching, thanks for what you do, and stay safe out there!