How to Invest in Real Estate With an IRA

While investing in real estate with an individual retirement account can be done, there are potential pitfalls and hurdles to manage.

"Most of my clients own real estate but outside of their IRA," says Kelly McLean Rindock, a certified financial planner at Steel Valley Investment Group of Raymond James & Associates in Center Valley, Pennsylvania. "There are only certain custodians that allow you to do it because there are so many hoops to jump through."

To do this, investors need to find a custodian, a company that can legally hold their assets, or a trustee who specializes in self-directed IRAs, also called SDIRAs.

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"It's not for everyone," says Kevin O'Brien, certified financial planner and president of Peak Financial Services in Northborough, Massachusetts. "It's for a savvy investor who has a sizeable net worth and is familiar with rental real estate because it's not a passive investment."

Matt Wilson, CEO of Equity Trust in Westlake, Ohio, whose company serves as a custodian for self-directed IRAs, says the IRAs are primarily used to invest in the rental market, to flip properties (purchasing, rehabbing and reselling in a short amount of time) or loan money to a builder or real estate investor.

Most, Wilson says, are purchasing single-family rental homes in the $50,000 to $125,000 range in smaller cities such as Indianapolis and Pittsburgh, or in Florida, Texas or California.

"Investors don't begin with a million dollars," he says, but most look for smaller, more manageable markets coupled with expertise on where to buy and rent.

How does this compare to a real estate investment trust? Unlike investing in a REIT, which is pooled capital, investors directly own or lend money to the real estate project when they invest via a self-directed IRA.

Liquidity is another major difference. REITs are a type of security that can be easily bought or sold on major stock exchanges, as opposed to owning real estate via an IRA that is illiquid and usually held for longer periods of time.

While a REIT typically includes a diverse portfolio of properties, O'Brien says real estate held within a SDIRA is usually more concentrated.

"Therefore, a higher degree of risk could be associated with fewer properties, less liquidity, potential vacancies and individual responsibility for maintenance costs," O'Brien says.

On the flip side, he says, there's more freedom in IRA.

"You have more say in what you are investing your money in since you are literally picking the assets," O'Brien says. "That means directly held real estate can give the right investor more control over which types of properties are invested in and their location."

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A tax deferred strategy. Investors with a high net worth who are looking for tax-deferred income before retirement use this strategy, as well as individuals who want to transfer property tax free inside the Roth IRA.

Investors holding real estate in a traditional IRA pay tax at ordinary income rates when the account is paid out, whether it is the property itself or a cash payment, O'Brien says. In a self-directed Roth IRA, investors are free from federal income tax on withdrawal if it's a qualified distribution -- a five-year holding period and the investor is either 59.5 or disabled.

Potential risks. Investing in real estate via an IRA is not a good idea for the average investor, McLean Rindock says. The tax reporting and administrative requirements are substantial and require a lot of work, she says.

"My biggest concern with owning real estate inside your IRA is how illiquid it can be. Yes, you may enjoy tax deferment, but 99 percent of investors would not be well equipped for this investment," she says. "While commodities and real estate certainly help you diversify, choosing to buy a property inside your IRA should not be a decision entered into lightly."

There are tax tradeoffs, O'Brien says. Beneficiaries do not get step-up in basis -- a readjustment of an asset, typically to the lower price when it was initially acquired -- upon inheriting property in an IRA, he says. Additionally, required minimum distributions may be difficult to meet if the property doesn't have a positive cash flow. Beneficiaries may also be unfamiliar with investment property management.

Understand what is prohibited. "The IRS is very specific about upkeep on a property and who will be using it," McLean Rindock says. "That means you can't use money from your self-directed IRA to buy a rental property for personal use."

A prohibited transaction may trigger an unrelated business income tax, and your entire IRA could become taxable, O'Brien says.

The investor can never use the property, nor can the investor's family or the fiduciary to the plan. Other prohibited transactions include if the property is acquired using borrowed funds, if the investor receives unreasonable compensation or uses the property as a security for a loan.

"You also can't be connected to the company that rents it," McLean Rindock says. "You can't repair the property yourself (or may not be reimbursed) and any and all costs must be paid from the IRA."

Review the fees. Some trustees will charge transaction or asset-based fees depending on the investment. Since there are very few trustees doing this sort of work, there's no incentive to keep fees low, says Warren Ward, CFP for WWA Planning & Investments in Columbus, Indiana.

The trustee will provide a valuation to the IRS each year and must make sure the asset is properly insured, Ward says.

[Read: 5 Ways to Turbocharge Your 401(k).]

"The investor is going to be paying those costs one way or another so, while a brokerage firm might charge $50 or so yearly for a typical IRA, the fee could easily be several hundred dollars for specific pieces of real estate," he says.

Dawn Reiss is an award-winning journalist in Chicago who has written for TIME, Reuters, Chicago Tribune, The Atlantic and Travel + Leisure and many other publications. Follow her on Twitter, Google+ and Instagram @dawnreiss.