Pros & Cons of Real Estate Funds in an IRA
Many investors desiring wealth appreciation look to real estate investing to earn an attractive return on their investment. One way to purchase real estate is through a self-directed individual retirement arrangement, which is only offered through certain brokerage firms. The major advantage of a self-directed IRA is the ability to use your IRA to invest in alternative investments.
Income Grows Tax-Deferred
A primary advantage of investing in real estate using your self-directed IRA is the ability to keep your income in a tax-deferred account. The real estate funds you keep in your IRA grow without taxation, and you pay federal income tax when you take qualified distributions at retirement. The real estate profits you roll back into your IRA are exempt from capital gains tax. Many people benefit from tax-deferred income growth because they are usually in a lower tax bracket when distributions begin.
Access to Capital
Another advantage is the ability to buy properties outright. In most cases, investors find it difficult to receive loans from traditional banks to invest in real estate. The contributions you make and profits you roll back into your account give you the necessary capital to buy real estate with cash. When you come across a potentially profitable real estate venture, you can act quickly to purchase the property. Avoiding bank loans allows you to save money in interest and fees.
Strict regulation is a disadvantage of using an IRA for real estate investing. Although a self-directed IRA allows you to invest in diverse assets, you can incur strict penalties if you're found engaging in self-dealing and non-arms-length transactions. For example, the IRS prohibits you from buying real estate from yourself, your spouse, your children or other relatives. The IRS can require you to pay federal income tax and capital gains tax on your profits. Creating wealth and tax benefits from property you already own is strictly prohibited.
Another disadvantage is that you must fund every expense associated with acquiring real estate investment property with your IRA. For example, the IRS can void your entire transaction if you use personal funds to pay for the down payment or closing costs. This means that you lose the tax advantages provided by the IRA and you must pay tax on your profits. You should leave an appropriate amount of money in your account to cover unexpected costs. Failing to do so may require you to use your personal funds.