One of the investment options available to anyone with a self directed IRA, or self directed 401k for that matter, is an investment in the real estate market. If you want to start from nothing and build/renovate your own properties, you need to tread carefully.
There are a range of restrictions put in place by the Internal Revenue Service (IRS). It’s remarkably easy to fall foul of these restrictions. It’s why a reputable custodian is essential for providing you with advice.
For the purposes of this article, we’re going to assume your self directed real estate fund will go towards either building a property from scratch or renovating an existing property.
Self-Dealing
Self-dealing is a serious penalty and can lead to a termination of your account plus an additional 10 per cent of the account’s value to be paid in tax. You need to avoid the appearance of self-dealing, so most custodians will tell you to stay as far away as possible from questionable practices.
You can’t lend or borrow to the business. The business must act alone and can’t connect to you or anyone within your family setup, even if it would make sense to do so.
What Work Can You Do?
You aren’t allowed to involve your family or yourself in the building or renovation of your properties. Investors need to pretend they’re managers and have no trade skills, even if they do. They need to employ independent tradespeople to carry out the work for them, even if this just happens to be a basic repair.
Of course, many of you will be thinking changing a light bulb by yourself won’t be noticeable. And in most cases it won’t because no money comes out of the business itself. You must remember you do these things at your own risk. If you do get caught putting sweat equity into the business, you have nobody to blame but yourself.
For most investors, it’s safer to simply pay for someone else to do the job. The financial penalties of getting caught far outweigh the cost of employing someone to simply do the job for you.
Financing
A self directed IRA does have financing options. It can borrow money from lending institutions. On the other hand, these loans can only be on a non-recourse basis. In other words, they have restrictions for the lender where if the borrower defaults they can only seize property. They can’t take any personal funds.
Such restrictions severely limit the lending options available to most self directed real estate funds.
Furthermore, there are no traditional mortgaging options. People who have small amounts of money will struggle to invest in real estate. In the past, some investors have started on small projects, such as mobile homes, before upgrading to condos and on to large houses.
The Difficulty of Diversity
The main obstacle you’ll face is the lack of diversity. Most IRAs will only have enough capital to fund a limited number of properties. If a natural disaster occurs, or if a tenant leaves, it could leave the fund in a difficult financial situation.
This is why most investment analysts recommend spending money on a complex where multiple people can live. If a tenant leaves, or doesn’t pay the rent, there are still other tenants to turn to.
Overall, opting to put all your money into real estate requires an understanding of the market. If you don’t understand the market, stick to something safer like bonds and precious metals like gold and silver. It’s safer in the long-term, and you can always move into real estate when you have more money available for your venture.
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