In our last article we discussed how to set up a real estate portfolio that can support retirement. This week, we will focus our attention on how to place your rental properties into a self-directed retirement account. While simply owning cash-flowing rental properties will finance your retirement, placing them in a self-directed retirement account will help you to cash in on the tax benefits.

Types of Self-Directed Retirement Accounts

Not all retirement accounts can fund or hold real estate investments. Only a self-directed retirement account can be used to hold investment properties. You have the choice of three different types of self-directed accounts that can hold real estate investments. Each of these accounts have specific requirements, guidelines and tax benefits.

Self-Directed Traditional IRA

This account can hold almost any type of real estate investment. This self-directed traditional IRA allows the holder to take state and federal tax deductions during the year contributions are made. If you withdraw any money, it will be taxed at ordinary income tax rates.

• A Limited Liability Company (LLC) must be created to hold the real estate investments.
• Penalty-free distributions are allowed at age 59 ½.
• Minimum distributions are required at age 70 ½.

Self-Directed Roth IRA

A Roth IRA receives no tax benefits in the year of contribution, but earnings and withdrawals are tax-free. There are some income-eligibility restrictions in order to contribute to this type of account.

• A Limited Liability Company (LLC) must be created to hold the real estate investments.
• Penalty-free distributions are allowed at age 59 ½.
• All income is tax-deferred.
• Qualified distributions are tax-free.
• Beneficiaries do not owe income tax but may owe estate taxes.

Individual 401(k)

If you are self-employed or a sole proprietor, then you may want to consider an Individual 401(k) account. A 401(k) can handle almost any type of real estate investment. You can take tax deductions that year. It is similar to a Traditional IRA.

• Penalty-free distributions are allowed at age 59 ½.
• Minimum distributions are required at age 70 ½.
• A Limited Liability Company (LLC) is NOT required.
• All work done on the investment property must be performed by an unrelated third party.

You can purchase investment properties using your 401(k) and what is more, the property does not have to go into the retirement account.  You can borrow up to $50,000 or 50% of the account balance, whichever is less. However, you must set the interest rate at least prime plus 1 percent and you will need to pay back the loan in less than 15 years. The loan is both tax-free and penalty-free.

Important Details about a Self-Directed Retirement Account

Now, before you run over to your tax advisor, there are a few really important facts that you need to know ahead of time.

• You cannot touch the income. All of the NOI must flow back into the retirement account. While you are presently sacrificing the benefits now, however, it will create compounding wealth in your retirement account – if invested wisely.

• You cannot touch the capital gains. If you decide to sell the property, the proceeds from the sale must stay within the retirement account.

• Transactions must be “arms-length.” The IRS disqualifies immediate family members or business partners from participating in a transaction involving a self-directed retirement account. This means that you cannot buy the family estate and place it in your retirement account.

• You can be the banker. You can use your self-directed IRA to lend money to others to finance real estate transactions. The borrower makes regular payments with interest back to the retirement account.

How to Choose the Best Self-Directed Retirement Account for Real Estate

Placing your investment properties in a retirement account is a smart move, however, you need to choose the right one. The tax ramifications of a poor choice can be severe. In our next article, we will show you the financial benefits of holding investment real estate in a retirement account and the tax implications of each. You will not want to miss that!