Investing with a SDIRA?

Question

Hello BP Community - relatively new to the forum, and had an SDIRA question - did I post this in the right place?

Trying to make sure I understand what owning a piece of real estate in an SDIRA looks like.....

Can anyone comment on my example?

Option #1:  $250K roll over IRA - invest in traditional mutual funds.  Assuming 8% annual return with compounding interest, would have roughly $531,700 after ten years.

Option #2:  $250K roll over IRA - convert to SDIRA.  Purchase $250K rental property outright.  Assuming 3% appreciation, property would increase in value to roughly $335,900 after ten years.

Also, during this time, rent of $1,600/month would be collected, or $19,200/yr.  x 10 years = $192K in rent.  $335,900 plus $192,000 in rent = $527,000 after 10 years.  Not accounted for in this example is property tax costs, insurance costs and maintenance costs.

Is 3% annual appreciation a reasonable historical assumption?  I understand this example does not account for annual rent increases, and the rent might be conservative.

From the little I know about SDIRA's, sounds like all rent collected would need to stay in the SDIRA account, and any expenses for the property would need to be paid out of the SDIRA account.

Do you lose the ability to write off costs like taxes, insurance, repairs, etc. when you hold a property in an IRA?  Would it make more sense to purchase a property outright - or to have some amount of mortgage on it?

Overall looks like a comparable investment to a traditional index fund over time, is the main attraction here the diversification angle?

Any insight would be appreciated......Thank you

Jeff Nash · Answer

@Brian Jasinski from your write-up it appears that you have a pretty good grasp on how it works.  You essentially need to treat the IRA as if it is self-sufficient and has the necessary balance to pay for all ordinary and necessary expenses associated with the rental and receives all of the income.  I can’t really say whether your 3% assumption is reasonable or not as it depends on location, market conditions, etc.  You mentioned financing and that can be done with nonrecourse loans (UDFI applies), but there is also an option to coinvest with someone that is not a disqualified person (lineal descendants).  You can get creative with how you invest, but just need to know the rules (disqualified persons and prohibited transactions).

As far as mutual funds, whenever I hear that word I think of a VCR or something outdated.  I would draw a comparison with low cost ETFs that have an expense fee of 20 bps or less instead. Generally if I see an “X” after a ticker symbol I pass on it.  There are always limited exceptions so I’ll just end on that.

MJ S. · Answer

@Brian JasinskiThere are a few other things to consider. Investing with your SDIRA must be a passive investment. That means, if a faucet needs to be replaced, you must hire it out. If it needs cleaning between tenants, you must hire it out. You, or any other disqualified persons can't be involved with anything related to repairing or updating the property. Some CPAs will advise that you hire a management company to collect rent and handle bookwork because technically, you shouldn't be involved in any of the operations... showing the property, collecting rent, etc. There are enough stiff penalties for breaking the rules (assuming you are caught) that would supersede any benefit you receive from investing through your SDIRA.

You also can't rent it to anyone in your family or use the property in any way that benefits you or a disqualified person. You can't vacation in your SDIRA owned property, use it for events, or live in it. All of those rules apply not only to you, but to any disqualified person... which is basically most of your family, and any entities owned by family members. In other words, don't think you're beating the system by renting the property to your son-in-law's LLC.

Another minor consideration is that there are costs associated with set-up and maintenance of your SDIRA. In the grand scheme of things, it's not a large expense, but still something to consider.

The pros and cons below are from an article online. I don't think Bigger Pockets will allow me to post links, but the pros and cons summarize the article well.

Pros

• Increase potential ROI of retirement savings by investing in nearly any type of asset.
• Rental property can hedge against inflation and economic fluctuations with a diversified retirement portfolio.
• Profits generated from a rental property in an SDIRA allow for tax-free growth.
• Property can be bought and sold within an SDIRA without using a 1031 tax-deferred exchange.

Cons

• Using all of your retirement savings to purchase a rental property in an SDIRA can significantly reduce diversification and increase potential risk.
• Rental property held in an SDIRA cannot be for personal use or family use (like a vacation home), including distant relatives or service providers of the SDIRA.
• All expenses must be paid for with SDIRA funds, third-party contractors must make the repairs and manage the property, and funds deposited in an SDIRA beyond annual contribution limits will incur significant penalties.
• Tax benefits, such as depreciation and operating expenses to create a paper loss for tax purposes, cannot be claimed with rental property held in an SDIRA.

I see that @Jeff Nash also referenced prohibited transactions in his reply, and that he's an accountant so he would probably have additional information to add if you wanted more details on what is and isn't allowed.

@Jeff Nash

Dmitriy Fomichenko · Answer

@Brian Jasinski,

Using leverage in an IRA will be subject to UBIT tax (note that truly self-directed Solo 401k is exempt from this tax on leveraged RE). However, it will increase your overall ROI since you are using OPM (you could buy two rentals instead of one).

You don't lose the ability to write off costs because those costs are not incurred by you but instead by the IRA, which is a separate legal entity from yourself.

James Sebastian · Answer

Also note that if you have a Roth IRA, then there is no tax ever on capital gains or income on the property (assuming you avoid UBIT and such)

Dustin Lauer · Answer

@Brian Jasinski

SDIRAs can also finance your deals and other investors deals, and at many firms can be used to invest as debt or an LP.  NuView in Lake Mary, FL is a great resource.

Kevin Crowell · Answer

Hi Brian -

Wow, you opened a can full of worms. It's a very good question. I think Chris took care of answering the information regarding the SDIRA. However, I wanted to shed some light on the mutual fund question as I was in the industry for about 10-15 years. The biggest thing you need to account for is fees. The average fee a fund manager take is 60-70%. Crazy, right? I am not telling you what is better, but there are a lot of things that Mutual Fund companies do not tell you. They do take a cut for the work they do. The hard part is that you don't see it unless you look hard at your investment. Let me know if I can help. Good luck.

Chris Seveney · Answer

@Brian Jasinski

With a self-directed, IRA, it acts alone and not connected to you personally

So when you own a property, there is no depreciation or any tax benefits. That is why many will use their hard earned cash to invest in real estate and their self-directed IRA to do other things like private lending, or invest in private credit funds. They do this, because Private lending is considered interest income and is typically taxed at ordinary income rates

What you have just shown though, is investing in mutual funds compared to investing in real estate is typically about the same return which historically they have been extremely close to each other.

Investing with a SDIRA?

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