When emotional turbulence overtakes investors thoughts, whether that be from an upcoming election, a virus, or other fear-inducing aspects of life, usually there will be a blogger or journalist, a DIY investor that relies on blogs for financial information, or an influencer YouTuber or golf partner think something they read is a really great idea. One of those ideas may be something called a SDIRA, or a “Self-Directed IRA in real estate.” (They assume real estate is less risky as an alternative investment to the markets).
SDIRA’s have been around for years, therefore, the first question you should ask yourself is, “If they’re so great, why isn’t everybody doing them?” That’s a great question! I have the answer for you.
They are extremely difficult for average investors to manage, with many possible pitfalls and penalties that could have your real estate kicked out the IRA status causing you thousands of dollars in penalties and taxes. This is the overall reason why it becomes impossible for the average investor to have a Real Estate SDIRA, but let us start from account opening.
The rules around IRA contributions are limited, so in order to put a property into an SDIRA, you must purchase most of the property with cash FROM AN IRA. You cannot use new money, since IRA contribution limits are currently at $6,000 per year, and $7,000 for catch up contributions. Unless you can purchase and entire rental property with IRA cash, you will not be able to do a SDIRA.
The property has rules. You, nor any family member or direct relation may be the seller of the property. These are called “disqualified persons” by the IRS. The inhabitants and renters of the property may never include disqualified persons. You nor any disqualified person may have anything to do with renting space, inhabiting, or profiting off the property with exception to the profits from rental that are your dividends returning to the IRA balance. (For example, you may not make money from doing your own maintenance).
Opening the account requires you to have a custodian, but the custodian responsible for records and reporting, is forbidden to give you any help or advice on record keeping, rules and laws governing the SDIRA, and will not help you if you get in trouble. Also, you must do your own reporting to the custodian. You are on your own with an SDIRA and better understand all the rules and regulations in running the property and the account. There are strict and plentiful record keeping requirements for you to fulfill while running and maintaining the property and the SDIRA.
Maintenance expenses are counted as contributions if the rental profits cannot cover the repairs or maintenance, and those maintenance and repair costs go above the annual IRA contribution limits. Therefore, if the apartment building has repair costs added to maintenance that go above your annual contribution limit, you are going to pay fees and penalties to the IRS for excess contributions. If the IRS finds record keeping mistakes, you could lose the SDIRA. In other words, the IRS could kick your property out of the IRA. The IRS could take away the tax free status, and apply penalties and income tax to the entire value of the property. You could lose the property itself if you cannot pay the IRS.
You do not get any deductions from any part of an SDIRA. As you may get deductions in usual investment real estate, or paying a mortgage, you cannot get any deductions from an SDIRA.
When you turn 72, you must take RMD’s from the IRA which means you must sell the property in order to pay out the IRS requirement. The only way to avoid selling, is to have much much more money than the value of the property, in another IRA or 401K, to cover the RMD, but since RMD’s are meant to diminish your retirement account balance over time, you will eventually be required to sell the property. If you can’t sell it, you will be penalized every year you do not take the RMD, usually 50% of the required amount is the penalty. If you take the entire property out of the IRA, you will pay taxes on the value of the property as income. If you take a property worth $200,000 or higher, you will be paying the highest tax bracket on income. Make sure you have $70,000 or more ready in cash (35%) to pay income tax on the value of the house.
Another risk to having and SDIRA, are fees. SDIRA’s have an overly complicated fee structure. You must make sure you understand the fees and affordability of them before entering an SDIRA.
The most significant risk of SDIRA’s during times of emotional panic, is fraud. The companies promoting SDIRA’s are not responsible for anything except selling you the idea. Fraud is not protected under SDIRA’s. Whereas investments like mutual funds in brokerage accounts are covered under limits by SPIC, for broker dealers or custodians going out of business, you have no protection with SDIRA’s.
So, would you rather be able to buy and sell stocks and bonds, without huge expenses, penalties, rules, regulations, and tons of work on record keeping and investment property ownership, or would you rather try to attain and manage an SDIRA? The choice is yours…the risk is also yours, and make no mistake, there is nothing less risky about an SDIRA’s than a regular IRA’s.
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