You’ve come to realize that you need real estate in your portfolio, but you just don’t have enough money to get started investing in real estate.

Or do you?

It turns out that you can actually invest in real estate with both your 401k or IRA (HSAs and Coverdells as well). So, if you are sitting on a nice little nest egg, you essentially have two options.

This first (and easiest option) is available to people with a 401k. Invest in real estate using your IRA or 401kYou can simply borrow up to $50,000 (or 50% of your portfolio, whichever is less) and invest it any way you choose. It has a 5-year repayment term where the balance will have to be paid back with interest (a couple points above prime).

The second is to use a self-directed account to invest in real estate. This option is a little more restrictive, but you can also use a lot more money to invest. The caveat is that you can’t borrow out of a self-directed account.

Before we get into the exact details of how to use your retirement accounts to invest in real estate, you should answer “should I use my 401k or IRA to invest in real estate?” Real estate is considered an “alternative” investment, and it has its own unique set of risks and rewards. It’s extremely important to understand what you’re getting into.

*Disclaimer* This is for informational purposes only. You should consult with the proper professionals before determining which type of accounts are right for you and if you should use a retirement account to invest in alternative investments. Nothing is this article should be construed as tax, financial, legal, or other advice.

If you already understand the risks of real estate, just skip right over this next section to one of the next sections.

Benefits of real estate investing with your IRA or 401k

There are a ton of reasons why people choose to invest, but this article will just cover some of the core reasons why people choose to invest in real estate.

Real estate adds diversification

Portfolio diversification with real estate is pretty well studied. Real estate has a low correlation with the broader stock market, which means it is an effective approach to diversification.

Also, returns in real estate have historically outperformed the S&P 500, as measured by returns from REITs.

So, by reducing correlation and adding higher performing assets, you will increase your overall returns and reduce risk.

Real estate provides long term passive income

Many stocks provide a dividend, though it’s usually relatively small (maybe 1-2%). In order to use any of the money you have locked in stocks, you need to sell some.

Real estate can appreciate as well, but the primary source of income is through rent.

With a typical 401k or IRA, you will need to withdraw money every year to cover your retirement. Meaning, every year your portfolio decreases (unless it is extremely large). The goal is for you to withdraw a low enough amount that it can hopefully last until the day you die.

That sounds like a race to the bottom if you ask me.

Real estate is different. Since rent comes monthly, you have a sustainable source of income to use each and every month. Using the rental income in retirement does not attrit the value of your portfolio like selling stocks would.

When your time does finally come, your asset will most likely be worth far more than when you purchased it and pay much higher rents as well.

Real estate can be leveraged

Simply put, you can leverage your money up to 4 or 5x when investing it in real estate. The mortgage markets are highly developed, financing is easy to obtain, and interest rates are amazingly low.

This can turn a 6% ROI into 10%+ very easily.

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Investing your 401k or IRA in real estate can allow you to use the power of leverage.

Let’s remember what leverage does – it allows you to do far more than you could do otherwise. $250,000 in the stock market is just that, 250k. The same amount in real estate lets you control over $1 million in real estate. This means higher returns for you.

Stocks can be levered as well but there are a number of drawbacks.

  • Generally, leverage is limited because the markets can swing rapidly.
  • Interest rates are much higher.
  • Leverage can be called if markets turn.

That’s why it’s not widely used among the general population.

Direct ownership avoids the costs and regulations involved with REITs and other funds

The reasons for diversifying with real estate are well established, but why not just add some REITs to your current portfolio?

Well, REITs are highly regulated and there are lots of costs involved with being publicly traded. You are also paying for layers of management. Investing directly in real estate avoids all those costs.

Real estate is considered the only “real” asset

By definition, real estate is considered “real property” while everything else is considered “personal property.” In other words, no more real estate is being made.

As the populations and economies grow, more and more land is needed for development. So, land and property values tend to closely match the growth of the economy.

Stocks value can go to zero if a company goes bankrupt. Companies close literally every day. Real estate, on the other hand, cannot go to zero value (except in some very special circumstances). There is always some residual value in the land.

This means real estate is an amazing hedge against inflation, and it will be valuable to you and your family for literally countless generations.

Risks of investing in real estate with your retirement account

Real estate isn’t without risk. In fact, it’s full of risks. Be fully aware that investing your 401k or IRA in real estate means you are putting retirement on the line. If you suffer a catastrophic loss in real estate, it can take a very long time for your portfolio to recover.

Let’s be realistic, though, stocks are full of risks as well – people are just more aware of those risks. Economies change, businesses go bankrupt or make bad decisions, and consumers sometimes just stop liking their products.

That’s why you don’t purchase stock in a company without doing a lot of research on it first. You should be willing to put in just as much due diligence (or more) when buying real estate.

Real estate is still subject to risks such as changes in the economy, changing demographics, or changes in tastes and preferences. In addition to that, there are 3 primary things that can eat away at your rental income or property value.

Tenant risk

This is probably the most cited reason why people shy away from real estate. Everybody is always afraid to get the “tenant from hell.”

…and you’d be right to fear it. Some tenants can be disastrous to your ROI and to your property.

That’s why it’s essential you learn how to be a great landlord, or simply hire a professional to manage your tenants and properties.

Property risks

The unknowns of real estate are another big factor that scares away many investors and includes things such as hidden insect damage,  structural, roof, pipes, etc…

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These are risks because

  1. You are probably not a contractor or inspector so you can’t identify them easily
  2. Even if you are a pro, these risks can go undetected and compound
  3. People sometimes defer small maintenance to save money which can also magnify these problems

You can minimize these problems by knowing your strengths and weaknesses and by hiring professionals to fill in the areas of weaknesses. This may include hiring pros to inspect and/or manage the property.

By hiring inspectors before purchasing a property, you will hopefully avert any major (avoidable) problems. You should also create a maintenance plan based off of the initial inspection.

The maintenance plan will fix all the problems with the property over time, and keep all maintenance issues current. This fixing/replacing things before they become a problem it ultimately saves you money in the long run.

Government

People often overlook this. The municipal government has a lot of power over local real estate. Essentially, they can plan projects, rezone, or do a ton of crazy things that will cause your values to plummet (or explode).

How would you fill if you bought a great property tomorrow and then a month from now you learn about a low-income housing project will go in on the same street.

That’s why it’s important to be involved with the town/city you will invest in and know what’s happening.

To Invest or not to invest, that is the question.

We’ve gone over many of the reasons to invest in real estate as well as some of the major risks. Please, do more research and reach your own conclusions. It is important to make an informed decision.

If you are not deterred and if you’ve decided that real estate is right for your portfolio, you need to figure out how you want to invest in real estate.

There is no “right way” to invest in real estate. What is most important is that you know your goals, then figure out how to set up your retirement account to achieve those goals.

The most common ways people invest in real estate with their IRA or 401k retirement account

There are probably dozens of ways to invest in real estate with your 401k and IRA. In general, though, there are 3 core ways that the vast majority choose to follow.

Private lending with your retirement account

The most common way people invest passively in real estate is by becoming a private lender. This falls under the category of debt investing.

It’s a really great way to invest – it’s lower-risk (because loans are backed by the real estate) and you need to invest very little time. Once you approve a deal and loan the money, you just need to collect the interest payments.

Abankdditionally, the costs of lending are usually borne by the borrower. If you need an attorney to prepare the docs and file the lien, simply charge it to the borrower.

You can borrow against your 401k or set up a self-directed account to become a private real estate lender. If you are just starting off as a private lender and want to make some small loans, you can easily borrow up to $50,000 from your 401k and lend it out.

Self-directed IRAs (or other self-directed accounts) are also great for private lending. You can give out much larger loans and fund entire purchases, rehabs, bridge loans, or anything else.

Example:

Let’s say a private lender chooses to lend $60,000 on a $100,000 property at 8%. If things go well, you will get 8% ($4,800 for the year).

If the deal goes bad, you can foreclose on the property and hopefully be able to capture most or all of your investment back. This is the safety provided by the lien.

The drawback – If the deal is amazing and the investor makes an extra $50,000, you still get just $4,800.

Which leads to the next way people use their retirement funds to invest in real estate.

Partnering on a real estate deal

This is similar to private lending, except on the equity side.

You won’t get a lien because you are part-owner. By accepting more risk, you gain more potential upside in the deal. Partners receive some portion of all equity and rent, depending on the details of the particular deal.

Example:

Going back to the example above. If you put $60,000 into the deal as a 50% partner, your return is entirely dependent on how the deal goes.

If the deal fails miserably, you could lose a lot of money (or even all of it if a lender forecloses against you).

On the other hand, if the deal is a smashing success and there is a $50,000 profit, you’ll get your half of that.

By accepting the risk of loss, you may earn far higher returns.

Buying a rental property

A lot of people will use their 401k or IRA to get their feet wet in real estate and buy a small rental.

The easiest way to go about this is to simply take a loan from your 401k and use it as a down payment on that rental property, as long as it’s less than $50,000.

People prefer this option because there are few rules that dictate what you can or cannot do with that loan. You can use it as a down payment and then get conventional financing for the remainder of the loan. You can also purchase it conventionally and use the 401k loan to fund the rehab.

The other option is to use a self-directed IRA, solo 401k, or some other self-directed account to purchase it. This option is a bit more cumbersome as the loans available to you are reduced and there are a lot of rules involved. The biggest is that you cannot directly manage the property (we’ll go over this a bit later).

Remember, though, this is not entirely passive and may require ongoing oversight or work from you.

Using your 401k to invest in real estate

If you have a 401k and a company match, it would be great to use it to invest in real estate, right?

The easiest way is to simply borrow up to $50,000 and invest it any way you choose. You will have to pay it back within 5 years, but there are very few rules other than that.

If you want to invest more, then you need a self-directed account. Typically, your employer gives several investing options with your 401k, but it is often limited in scope. Unfortunately, only about 1/3 of employers offer a self-directed 401k option.

If you cannot set up a self-directed 401k you can roll it over into a self-directed IRA in order to open up more options. Be careful, though, a self-directed account cannot provide the $50,000 loan. That’s why it’s important to know your goals first, then choose the best path.

Restrictions a self-directed IRA for real estate investing

IRAs are a bit more diverse and there are a lot of options including a Roth, SEP, or Traditional IRA. You should consult with a tax professional before setting up an IRA (or self-directed IRA) and especially before you roll over a 401k into one.

Limitations of using your self-directed IRA

The real estate you buy must be a business property

It cannot be a personal residence, second home or occasional rental. Also, you can’t use your IRA to buy a property you already own; it has to be a new purchase directly into the IRA.

This means it cannot be a personal residence, second home or occasional rental. Also, you can’t use your IRA to buy a property you already own; it has to be a new purchase directly into the IRA.

Your IRA cannot purchase property owned by you or a disqualified person.

  • Fiduciaries (which in the case of a self-directed IRA includes you, as the IRA owner)
  • The following family members of the IRA owner:
    • Spouse
    • Parents
    • Grandparents and Great-Grandparents
    • Children (and their spouses)
    • Grandchildren and Great-Grandchildren (and their spouses)
  • Service providers of the IRA (e.g., IRA custodian, CPA, financial planner)
  • An entity (such as a corporation, partnership, LLC, trust or estate) of which 50% or more is owned directly or indirectly or held by a fiduciary or service provider; also a partner which holds 10% of a joint venture of such entity

You cannot have indirect benefits from property owned by a self-directed IRA. 

You cannot occasionally vacation in your rental or receive other benefits. It’s intended to provide for a future retirement, not to give benefits now.

This rule also applies to disqualified persons.

Uniquely title each IRA investment.

All documents need to be titled properly because you and your IRA are two separate entities. Often the title looks like: “Equity Trust Company Custodian [for benefit of] (FBO) [Your Name] IRA.”

Real estate in an IRA can be purchased with financing.

It must be non-recourse and is also subject to unrelated business income tax (UBIT) pursuant to Section 511 of the Internal Revenue Code.

Other financing sources can include partnerships (that’s why it’s so popular) and by using undivided interest.

Real Estate Income Must Return to Your IRA.

If you receive and cash any checks from the investment, it will be considered a distribution and is subject to taxes and penalties.

All expenses must be paid from the IRA.

Every repair needs to be invoiced to the IRA and paid from that account.

It’s important to note that you cannot do work on the property yourself. Since you and the IRA are considered separate entities, and any work is a form of sweat equity, the IRS prohibits this. This leads to the last rule:

You must use a third party for management.

The IRS rules don’t specifically say this, but most self-directed IRA custodians require it. You can see how it’s easy to interpret the previous rule and then assume that management would also be considered providing free work to the IRA.

So, it will be important that you have a management company directly manage your property. You could also partner on the deal and have the other partner as the manager.

How to open and use a self-directed IRA to purchase real estate

Step 1) Determine what kind of account you want

Many options are available for investing. This article obviously focuses on retirement accounts, but your options include:

  • Health Savings Account
  • Coverdell Education Savings Account
  • Traditional IRA
  • SEP IRA
  • Roth IRA
  • Solo 401k
  • Roth Solo 401k

I have had some extensive conversations about setting up a Coverdell for my daughter and using that to fund her future education. It is definitely something I’ll be doing soon.

Step 2) Identify the custodian or administrator

The first thing you should do is find a local company to help you. Start by searching “self-directed IRA custodian (City, State)” so, you might type into google “self-directed IRA custodian in Dallas, Texas”.

If you can’t find a local one, here is a great list of custodians and administrators online.

Just in case you may are wondering about the difference between custodians and administrators, I found a great resource for you as well.

Step 3) Set up the account

The actual setup is pretty straight forward. Once you have identified a custodian and the type of account you want, you just need to fill out the paperwork and get it funded.

One note, though. I have been told by several IRA professionals to avoid IRAs with “checkbook control” or a “checkbook IRA.” Essentially, the custodian is giving control of the checkbook to you instead of taking care of the payments through the company.

The reason – you are taking over some “management” of the company. It was also explained to me that there are no specific IRS rules that allow checkbook control, and it’s based on a limited number of court cases and hasn’t actually been challenged yet.

I personally don’t want to be stuck on the wrong side of things with my retirement account until the rules are a bit more clear-cut.

So, do some research and decide exactly how you want this account set up.

Step 4) Find a deal

Either you find a property to purchase or someone brings a deal to you and you decide to fund it.

If you decide on being a private lender or partner, you should focus on finding other investors instead of finding a deal. You can do this by finding local real estate investing clubs or meetups.

Step 5) Fund and manage the property correctly

Even the initial offer and earnest money need to come from the IRA. Remember, you cannot write an offer in your own name then transfer it to your IRA.

The IRS may consider it a prohibited transaction to pay the EMD then transfer it to the IRA. Similarly, you cannot reimburse yourself afterward.

This applies to everything from initial deposit all the way through closing.

Also, it’s important to keep an eye on how expenses are paid and how management is conducted.

What’s your experience with using your IRA, 401k, or other accounts for investing in real estate? Leave your comments.