If you think that your IRA investments are limited to stocks, bonds, and mutual funds, you’re wrong. Self-directed IRAs can own real estate, too. Here’s what you need to know about investing in property for your retirement account.

What is a self-directed IRA?

Self-directed IRAs, as the name implies, are controlled by you, rather than an account custodian. Banks and brokerage companies, the most typical IRA account custodians, limit your choices to things like certificates of deposit, mutual funds, stocks, annuities, and other products that they earn commissions on. But if you want to take control and open up more kinds of investments, you need a custodian that allows self-directed IRAs.

Many types of IRAs can be converted to self-directed accounts including traditional IRAs, SEP IRAs, Roth IRAs, 401(k)s, 403(b)s, Coverdell Education Savings (ESA: 3.42 ,0.00 ,0.00%), qualified annuities, profit sharing plans, money purchase plans, government eligible deferred compensation plans and Keoghs.

Although this article focuses on real estate investing, self-directed IRAs can invest in trust deeds, franchises, secured and unsecured notes, limited partnerships, private stock and other nontraditional investments — even race horses! You can search online and find dozens of companies that handle these types of investments.

Most folks buy income-generating rental property for their IRAs, and some choose to convert a rental to their primary home once they retire. Note: your custodian is a neutral party; it can’t advise you about what property to buy, so you’ll have to do your own due diligence. A skilled real estate agent, attorney and perhaps an accountant or finance pro can be helpful here. If you want extra help, there are companies that specialize in finding real estate for retirement investing, but first you will need to apply and be approved for a non-recourse loan. If you plan to buy and flip properties in your IRA, an IRA LLC (absolutely get an attorney to set this up for you) can facilitate the frequent buying and selling of properties, and even allow you to add and subtract investment partners.

A mortgage on the IRA property

If you need to finance your income property, the mortgage must be a non-recourse loan. That means the lender must not be able to go after you and your assets in the event of a default when the sale of the property doesn’t cover the entire outstanding balance. Many states require that mortgages on primary residences be non-recourse; that doesn’t generally apply to mortgages on investment property. You can find such financing by asking mortgage lenders for non-recourse IRA loans. You should understand that the mortgage rates on these loans will likely be higher than current mortgage rates for traditional purchases.

In addition, you can’t use any non-IRA funds to close on the mortgage — it is absolutely illegal to co-mingle any of your non-IRA money with IRA account funds or assets. Finally, beware of adjustable rate mortgages — if your mortgage payment makes an unexpected jump, your account could end up short of funds and in trouble. A fixed-rate mortgage is a far safer option when investing for your retirement.

Rules, rules, rules!

Rules governing these accounts must be followed to the letter or you could find yourself paying very stiff penalties. For example, you can use your self-directed IRA to buy your future retirement home, but you can’t live in the home until you retire. You also cannot move property that you already own into your IRA. If you purchase an asset like a vacation home for your IRA, you can’t use it for your own personal benefit. This is called self-dealing and could kill all the profit in your IRA. For example, if an investor took $100,000 from a $1 million IRA to buy land with a rental cabin on it, then took some business partners hunting or fishing on the property, he’d be guilty of self-dealing. The IRS may find out (say he or his partners write off the hunting trip), and then the entire IRA, not just the $100,000 investment in the property, is considered “distributed.” That means if you’re under 59 1/2, the money gets taxed as ordinary income plus a 10% penalty is collected.

Here are additional examples of prohibited transactions:

  • Renting IRA-owned property to family members or a spouse
  • Lending IRA cash at a below-market rate to a friend
  • Paying yourself from income derived from an IRA investment
  • Personally guaranteeing a loan on an IRA asset

To take advantage of the IRA’s tax benefits and avoid costly penalties, you must be sure that there is enough in your account to take care of the expenses that come with owning rental property. Taxes, maintenance, management fees, and other expenses must come from funds that are in the IRA. Likewise, all income must stay in the IRA account. Make sure there is enough cash in the account to cover expenses when your tenants move out and have not yet been replaced by new ones. Mortgage lenders generally agree that you should have access to at least six months of expenses for each rental property you own.

Understand the risks

Those with self-directed IRAs can make a lot more money on their investments than those who play it safe. But real estate, as anyone who hasn’t been hiding under a rock during the last three years knows, is far from foolproof as an investment. If investing in property will tie up the majority of your IRA, you could find yourself dangerously under-diversified.

This article was originally published on HSH.com.2013. Contact First Western Federal Savings Bank to begin your non-recourse loan application and your real estate investments today.