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Where Self-Directed Investors Get Into Trouble When Investing in Real Estate

Self-directed IRAs can be an excellent vehicle for savvy retirement investors who want to have more control over their portfolios. This type of IRA can hold alternative assets, such as real estate, that provide diversification to a portfolio and may lead to expanded future wealth potential. The ability to invest in real estate allows self-directed IRA owners to capitalize on investment opportunities according to their appetite for risk, which could lead to increased ROI. Putting your money in physical assets like a piece of land or rental property can also serve as a hedge against stock market ups-and-downs. Sound like a no-brainer?

Many investors hear about the upside of buying real estate in a self-directed IRA and decide to jump in. This can be a mistake if you are new to this type of investing and haven’t taken the time to perform adequate due diligence.

Here are a few ways that investors can get into trouble when using a self-directed IRA to buy real estate.

Not Doing Your Research

Whether you’re investing in real estate in a self-directed IRA or buying your first home, you need to do your background research in order to make a wise decision. For example, it’s important to learn relevant facts about a property’s location. Does the town have good public transportation, shopping, or other amenities? Is it generally a safe neighborhood and are adjacent properties well-maintained? You should also obtain a list of sales comparisons in the area. Knowing a property’s value can help you gauge its likelihood for growth. Find out about its property taxes, rent potential, and if it carries any open liens.

It’s tempting to act fast on a hot tip or a great price, but if the investment is not sound, you’re putting your portfolio at risk. That risk could be greatly mitigated by simply doing your homework.

Not Being Diversified

A great advantage of the self-directed IRA is the ability to diversify your portfolio beyond traditional investments like stocks and bonds into alternatives like real estate. Just as you wouldn’t hold stocks from only one sector of the market, you shouldn’t invest in only one type of real estate. The same reason applies – diversification can lessen the impact of fraud, price drops, and fluctuations in a particular market.

Furthermore, concentrating your money in only real estate doesn’t provide the liquidity your portfolio may need. Accessing cash from your self-directed IRA is an important consideration in order to pay for things like repairs and taxes on your property as well as to meet your IRA’s minimum distribution requirements once you’ve reached age 70 1/2.

Not Being Aware of the Rules and Regulations

Real estate investments in a self-directed IRA can certainly be profitable, but at the same time they can be costly if the IRA owner doesn’t follow the rules and regulations set forth by the IRS. The IRS Prohibited Transaction Rules describe what you can’t do, making awareness and understanding of them paramount for IRA owners.

Disqualified persons include the IRA owner and certain family members, who cannot benefit directly or indirectly from certain self-dealing transactions involving the IRA’s assets. For example, your self-directed IRA can’t buy a property you already own, nor could you live in a house owned by your IRA. You cannot personally pay any expenses related to the properties owned by your IRA. Even putting your own sweat equity into a property may be prohibited.

The consequences of ignoring these rules include excise taxes and disqualification of your IRA. If this happens, your entire IRA is treated as distributed to you and subject to income tax and potential penalties.

There are great reasons to invest in real estate within a self-directed IRA. These investments can be lucrative, but they are also complex and require solid preparation by the IRA owner. Putting in the time and doing your homework, however, may lead to greater future wealth.

If you’re already invested in real estate and have questions, or would like to diversify your self-directed portfolio, schedule a call with an iPlanGroup professional below.

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