What Every Financial Advisor Should Know About Self-Directed Real Estate Investing
Things are looking up for investors; the stock market is back to record levels amid strong economic data. Yet the events of 2008 are still fresh for many retirement investors. Appetite is there for ways to invest that aren’t directly tied to the stock market and its volatility.
Enter the self-directed IRA. Your clients may find this to be an attractive retirement investing vehicle for its diversification potential. A variety of alternative investments can be held in this type of account, and among the most popular is real estate.
Real Estate Choices in a Self-Directed IRA
At one time or another, your clients have likely asked whether real estate makes sense for them and how they can get started. Self-directed IRAs are great for investors who want to have more control over their investments and flexibility with their portfolio, and there are a lot of options when investing in real estate.
You can invest in property for the long-term capital appreciation or the ongoing cash flow provided by rental income. In the short-term, investors can find instant equity in purchasing property valued below market or enjoy the profit potential of a “flip.” IRA owners can purchase virtually any type of real estate including homes and apartments, commercial property like office buildings and shopping plazas, or pieces of land.
There are also indirect investments that may provide an attractive income stream including mortgage notes, trust deeds, and tax liens, which use real estate property as collateral. With these investments, IRA owners don’t need to worry about vacancies or costly repairs that come with owning physical property.
Benefits of Real Estate for IRA Owners
Greater ROI potential. A self-directed IRA boosts investors’ ability to make wealth optimizing decisions. IRA owners can take advantage of real estate investment opportunities with great return potential because they have control over the level of risk they’re willing to incur. Furthermore, with real estate there is potentially both an equity component and a cash flow component that helps to build wealth.
Natural hedging. The ability to invest in physical assets like land or buildings provides protection against price movements and market volatility. Commodities such as real estate are also an excellent hedge against inflation.
Tax advantages. With real estate purchased in a self-directed IRA, any gains from the sale of property would be tax-deferred (traditional IRA) or tax-free (Roth IRA).
Things to Consider
Real estate is a complex investment. In a self-directed IRA, the IRA owner is making the investment decisions. Your clients should be savvy investors who have some knowledge of real estate before they take the plunge.
There are rules and regulations. The IRA Prohibited Transaction Rules prohibit disqualified persons (including the IRA owner and certain family members) from engaging in certain types of self-dealing transactions like selling property to the IRA or living in property owned by the IRA. The consequences of not following the rules can be fierce and include costly taxes and penalties as well as the disqualification of the IRA.
Be aware of the costs. Owning real estate can include expenses like repairs, homeowner association fees, and taxes. Because these expenses must be paid for from the IRA, the account needs to hold a certain level of cash. And since real estate is generally illiquid, making sure there is cash available is another consideration for IRA owners.
Your clients may have pie-in-the-sky ideas about real estate investing. They’ve probably heard stories about big payoffs, making it easy for them to be seduced by enticing deals and willing to use a disproportionate amount of funds in real estate investments. As long as investors keep the basics in mind – stay diversified and stick to a comfortable level of risk tolerance – real estate investing can be an effective way to build wealth and make the most of a self-directed IRA.