Article originally published in U.S. News & World Report by contributor Rebecca Lake.
A changing economic environment that brings 0% interest rates can open up new possibilities for investors. One of the areas that may offer the most potential to capitalize is real estate.
David Freudenberg, founder and senior vice president of operations at David Buys House Florida, says savvy investors can take advantage of low rates to purchase long-term rental properties and refinance higher-interest loans. A self-directed individual retirement account could be a prime place to hold real estate investments in a zero-rate environment.
“This is a type of IRA that allows for alternative investments not allowed in a traditional IRA,” says Melody A. Juge, founder of Life Income Management. These alternatives include real estate, along with limited partnerships, precious metals, commodities, private placements and tax lien certificates.
Contribution limits for a self-directed IRA are the same as traditional or Roth IRAs. But unlike a regular IRA, self-directed IRAs leave the investment choices up to you.
“The benefit of a self-directed IRA is that people can invest in assets that they know and understand,” says Patrick Hagen, national director of business development at Strata Trust. “This allows investors to diversify their retirement portfolio to include noncorrelated alternative investments.”
Adding real estate to a self-directed IRA when interest rates drop to zero could be a profitable move. But there are a few rules to keep in mind before venturing in:
• Find a qualified custodian.
• Don’t skip due diligence.
• Avoid self-dealing to stay on the IRS’ good side.
• Watch out for other tax triggers.
Find a Qualified Custodian
Setting up a self-directed IRA to invest in real estate is a little different from opening a traditional or Roth IRA at an online brokerage. You’ll need to choose an IRS-approved custodian to open your account.
Custodians can include banks, insurance companies and other financial institutions. They have three primary functions: holding account assets, processing trading transactions and keeping records for the IRS.
Just don’t expect your self-directed IRA custodian to offer guidance on how to invest in real estate or other alternatives within your account.
“SDIRA custodians are prohibited from giving investment or financial advice,” Juge says.
What that means, essentially, is that you’re on your own when it comes to selecting real estate investments to include in a self-directed retirement account. “As an owner of a self-directed IRA, your future is in your hands,” Freudenberg says.
Don’t Skip Due Diligence
Even when rates are low, it’s still important to research property investments thoroughly before adding them to a self-directed IRA portfolio.
For instance, if a rate drop happens in response to a broader recession affecting the economy, then the location can be critical. If you’re interested in owning one or more rental properties, you may want to target areas that continue to see a steady flow of traffic. A suburban area that’s near plenty of grocery stores, gas stations and other necessary businesses that consumers still frequent during an economic slowdown, for example, could be a profitable choice.
In addition to location, timing also matters.
“Now is the time to take advantage of these 0% loans and purchase real estate at a lower value than normal,” Freudenberg says.
When buyers begin hoarding cash in reaction to changing economic conditions, demand for housing can decline. If that’s matched by a drop in supply, it may be a matter of time before the market bottoms or levels out. That could be your chance to purchase properties at discounted rates using 0% loans, Freudenberg says.
Remember, however, to consider the potential return on investment, particularly if you’re borrowing money to purchase a property inside a self-directed IRA. Low rates may mean low monthly payments, but you need to have a good sense of how much cash flow a property will generate, both in the near term and once the economy begins to recover.
Avoid Self-dealing to Stay on the IRS’ Good Side
One very important difference between a self-directed IRA and a regular IRA is how they’re regulated. The biggest thing to watch out for is self-dealing, which means benefiting personally from self-directed IRA activities.
“There are rules associated with holding alternative investments inside of a tax-deferred IRA,” Hagen says. “Self-directed IRA assets need to be held strictly for investment purposes.”
Some of the guidelines laid down by the IRS prohibit things such as:
• Borrowing money from the IRA.
• Selling property to it.
• Using it as security for a loan.
• Buying property for personal use with IRA funds.
These rules don’t just apply to you as the account owner, either. They also apply to your beneficiary and any disqualified person, which includes spouses and children.
For example, you couldn’t purchase a rental property with a self-directed IRA and then allow your children or grandchildren to stay there on vacation. Tapping the property’s equity for a loan, even if it’s to improve the property, is also a no-no.
Violating the self-dealing rules could negate your strategy of investing in real estate for tax advantages, Juge says. If the IRS determines that self-dealing has taken place, amounts distributed to you could be treated as 100% taxable, meaning you’d lose the tax benefits of having a self-directed IRA.
Watch Out for Other Tax Triggers
One last thing to be aware of when buying property inside a self-directed IRA is something called Unrelated Business Income Tax, or UBIT. This tax applies to the taxable income of unrelated trade or business activities. Vincenzo Villamena, managing partner of Global Expat Advisors, explains how it can work for IRA investors who self-direct.
“Let’s say an IRA buys a rental property for $100,000, and $40,000 came from the IRA and the rest from a nonrecourse loan. The property is thus 60% leveraged, and as a result, 60% of the income is not a result of the IRA’s investment but the result of the debt invested,” Villamena says. “Because of this debt, that is not retirement plan money. The IRS requires to be paid on 60% of the income.”
Based on the math from that example, if there’s $10,000 of rental income on the property, then $6,000 would be subject to UBIT. It’s important to keep the amount of tax you might owe in mind when leveraging IRA assets to purchase real estate. If the amount of tax owed would outweigh your return on the investment, then it may not be the right move.