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Many investors want to invest in real estate but feel as though they need a large amount of liquid capital at their dispense. The truth of the matter is you do typically need some capital to start investing in real estate, whether you are making a down payment on a residential property or joining a syndication to stake your ownership in commercial property. However, capital doesn’t need to be liquid and if you’ve been investing in your 401k or IRA you can direct those funds into alternative assets such as real estate. The tool to do this is called a Self-Directed Individual Retirement Account (SDIRA), which is the topic of this article.
What is a Self Directed (SDIRA)
A SDIRA is the same as any other IRA. They are both investment tools set up by the individual manager and have maximum annual contribution amounts set by the IRS. The key difference is that a SDIRA can invest in alternative assets. Larger brokerages and banks such as Charles Schwab or Wells Fargo, typically offer traditional IRAs but these are not allowed to direct your funds into an “alternative asset” even if they have your authorization. They are limited to investing in assets such as securities, bonds, and stocks. SDIRA(s) allow you to invest in alternative assets such as syndications, precious metals, crypto currency, and promissory notes.
Investors start an IRA with the expectation that it will grow over time and be available as a source of income or at least a supplement once they attain retirement age. Typically, investors start with Traditional or Roth IRA(s) offered through larger institutions that invest in buckets of stocks, securities, and bonds, proportioned in a manner most appropriate with your current age and risk tolerance. It’s usually later in an investors journey they learn of private equity or alternative investments. Once an investor learns of alternative investments and decides it will be a good option to diversify their IRA, they can transfer their IRA or a portion of it to a SDIRA. The initial process of starting a SDIRA is a bit different from the normal IRA(s).
How to Get Started
First – an investor looking to use a SDIRA to invest in a syndication must first open and start the SDIRA. This requires you to simply open an account with a company that offers SDIRA (s). There are various companies that will structure these for you. They can be large or smaller specialized financial institutions.
Second you must get the account funded. This requires you to transfer money to the SDIRA much like a traditional IRA. The transfer can be from traditional IRA or 401k. Alternatively, you could start making initial contributions, but you must comply with current annual contribution limitations.
Third – Your SDIRA company will typically create a Manager Managed Limited Liability Company (LLC) or a Trust. The LLC or Trusts will serve as the IRA’s Delf Directed investing platform. You will be appointed as the Manager or Trustee authorized to make all investment decisions.
Fourth – You can begin making investments by wiring funds or writing a check. Of note, the company you purchased your SD-IRA through will typically do some due diligence to investigate the alternative asset you are purchasing. However, this due diligence is limited to making sure the syndication is not going to violate SEC or IRS rules and regulations. They will not review the estimated return or underwriting of the investment.
Legal Requirements
An important concept to remember is that an IRA is exclusively meant to provide benefit for you in retirement. What this means is that you cannot personally benefit from appreciation or cashflow earned from an alternate investment pre-retirement. This limitation applies to you and your immediate family, collectively known as disqualified people. What does this limitation mean for real estate investing?
Cannot Purchase Primary Residence – You cannot use your SDIRA to purchase a residential property to which you live in. This includes multifamily and vacation homes. You can, however, purchase an investment property and move in once you reach retirement age. In this instance you will be withdrawing the property from your SDIRA.
You cannot perform work on the property – Working on a property or making improvements is often called sweat equity. This term really means a non-cash contribution to your SDIRA which of course would amount to Self-Dealing and benefiting you before retirement age is attained. You can, however, perform an asset management function, e.g., screening tenants, hiring contractors, anything that amounts to desk work.
Income and Expenses – All income and expenses must flow directly into and out of your SDIRA. Always remember the SDIRA is set up as an LLC or Trusts, meaning these are separate entities from you as an individual. That said you cannot commingle funds with personal accounts and the entity directing IRA funds.
Conclusion
The SDIRA is a great tool for investing in alternative investments. By far the number one alternative investment is real estate. This is likely due to its track record of outpacing index funds, tax advantages, and offerings available to unaccredited investors under the right circumstances. If you are interested in transferring a conventional IRA to a SDIRA you should always talk to your financial advisor and understand the risk involved.
