Your Roth Individual Retirement Account (IRA) is more than just a savings account. You can use your Roth IRA to hold all kinds of investments – including real estate. Find out whether this is the right strategy for you in this landlord’s guide to investing in real estate using a Roth IRA.
1. What is a Roth IRA?
Let’s start with the basics.
There are two types of IRAs. “Traditional” IRAs allow you to defer income tax on contributions until the time they’re withdrawn. Your contributions are deducted from your income for tax purposes in the year they’re made, but you have to pay income tax on your withdrawals.
A Roth IRA flips this paradigm upside-down. While there are no tax breaks for contributions, you don’t have to pay taxes on investment income earned in a Roth IRA or on withdrawals. The money in your account is 100% yours to keep as long as you’re older than 59½ at the time of withdrawal.
2. What Investments Can I Hold in a Roth IRA?
Any investment your traditional portfolio would comprise can be held in a Roth IRA. Stocks, mutual funds, exchange-traded funds (ETFs), bonds, and certificates of deposit (CDs) are all examples of allowable investments. You can also invest in other securities like derivatives and precious metals.
You can also hold investment real estate in a Roth IRA. You can hold real estate securities by investing in real estate investment trusts (REITs), but you can also hold real property like a house or condo.
3. What Kind of Real Estate Can I Hold in my Roth IRA?
If you’re using a self-directed Roth IRA, you can buy any kind of real estate as long as it’s solely for investment purposes. That means you and your family can’t use the property, or any part of it, for any reason at any time.
Aside from that, you’re free to operate your investment property in any way you see fit. You could buy a downtown condo and use it for short-term vacation rentals. You could buy a house or multi-unit building and rent it out. You could even buy a parking space and lease it using your Roth IRA.
4. Why Would I Want to Use my Roth IRA to Invest in Real Estate?
Using your Roth IRA to invest in real estate can be advantageous for a few reasons:
Simplifies accounting and tax filing
Holding real estate in a Roth IRA can make your accounting and taxes much easier because it is a completely separate entity from yourself. While you’re free to move money in and out of the account, the account itself earns rental income and pays for expenses. You’ll still have to stay on top of your rental property bookkeeping, but you’ll be spared from reporting it all on your taxes.
Potentially saves money on taxes
Investment properties earn money in two ways: through rent and through appreciation. When you hold your investment property outside of a Roth IRA, you have to pay income tax on the rent you collect every year, as well as capital gains tax on any windfall when you sell. All of this tax is avoided when your property is held in a Roth IRA.
Freedom to grow your business within your Roth IRA
Just as you can buy, sell or trade any other investment in your Roth IRA, you can buy, sell or trade your investment properties as you see fit without incurring any taxes.
5. What are the Downsides of Investing in Real Estate Using a Roth IRA?
Investing in real estate through your Roth IRA has its downsides:
Very limited access to financing
Traditional rental property loans are all but out of the question when buying an investment property in your Roth IRA. That’s because the only way to get money into your Roth IRA is to contribute it personally and you can’t secure any loan against your IRA. Instead, you’ll have to fund your Roth IRA from other sources, whether it’s cash, an unsecured loan, or a loan secured against a different property (HELOC). You can also look into a non-recourse loan, which secures the debt against the property itself rather than you or your IRA.
No income tax deductions
Remember how all of your investment property’s income and expenses are run through the account when you invest in a rental property through your Roth IRA? While this structure makes filing your taxes a lot easier, it also means you can’t deduct any Schedule E expenses. If your property has low or negative cash flow, you might come out ahead by keeping it out of your Roth IRA.
Contribution room could cause cash flow problems
There are limits to how much money you can contribute to your Roth IRA. In 2022, you can only contribute a maximum of $6,000 if you’re 49 or younger or $7,000 if you’re 50 or older. If you make too much money ($144,000 per year for an individual), you may not be able to contribute at all. If your Roth IRA runs out of cash and you run out of contribution room, there could be serious consequences.
You and your family can’t use the property
Let’s say you invested in a condo using your Roth IRA and now want to allow your child to live there while attending college. Doing so would be a “prohibited transaction,” which, according to Investopedia, means your entire Roth IRA would be added to your income and taxed based on early distribution rules.
Managing the property yourself is a gray zone
Because your Roth IRA owns the property, the IRS could take the stance that you doing work on the property yourself is no different than making a sneaky withdrawal or contribution behind their back – jeopardizing your IRA’s tax status. Hiring a property manager is the easiest way to stay on the IRS’ good side, but you may be able to set up a legal structure that allows you to self-manage your property without breaking any rules.
6. How Can I Purchase an Investment Property Using my Roth IRA?
You can’t just buy a house and declare it to be part of your Roth IRA. You will need to open a self-directed Roth IRA with a custodian like a bank or a brokerage and buy the property using the account similarly to how you would buy any other investment in your Roth IRA. Your custodian will take care of all the necessary reporting and paperwork to register the investment in exchange for a fee.
The Bottom Line
The Roth IRA can be a useful tool for investing in real estate in certain circumstances. It’s most likely to be a good strategy if you have the available cash to invest and believe it will be tax-advantageous over the long run to trade annual deductions for long-term tax-free growth. However if you want to invest in property that you or your family will use, or if you can’t comfortably purchase and operate your property within the confines of your Roth IRA, you might want to look for a different strategy.
The primary upside to investing in rental property using your Roth IRA is the potential to save money on taxes over the long run. Not only will you not pay income tax on your rental income, you will also be spared from paying any capital gains tax when you sell your property.
Yes, you can invest in real estate using a traditional IRA, similarly to how you would do so using a Roth IRA. However, traditional IRAs are taxed differently from Roth IRAs, so it’s important to do your homework to make sure you’re using the best IRA for your financial situation.
In addition to the usual expenses involved in investing in real estate, you’ll also need to find a custodian for your Roth IRA. Typical fees include a setup fee of a few hundred dollars, plus ongoing fees that may be based on the number or value of your assets, as well as fees per transaction. Real estate investors typically spend between $200 - $2000 per year in Roth IRA fees.