One of the available investment options for an individual retirement account (IRA) is real estate. Traditional brokers don't usually offer real estate as an investment, which requires you to open a self-directed IRA to access it. If you use this method of investment, there are certain rules that you have to follow.
A self-directed IRA is a type of retirement account in which you can have full control over where your money goes. With a traditional broker, you typically only can invest in stocks, bonds, mutual funds and exchange-traded funds. With a self-directed IRA, you can oversee where your money goes, and you can choose from different types of investments. This is a type of IRA that you'd need to invest in real estate.
When you invest in an IRA, you have to avoid transactions that would be considered "self-dealing." This is a restriction that's placed on IRAs by the Internal Revenue Service (IRS). This simply means that you can't engage in any investments that would potentially benefit you directly. If the investment benefits you other than by providing a return on your investment, it could be considered self-dealing. For example, if you use your retirement dollars to help grow a business that you personally own, this would benefit you immediately by giving you extra profits in your business. You can only invest for the long-term prospects of earning money for your retirement account.
When using a self-directed IRA to purchase a piece of property, be careful with vacation homes. People sometimes try to get away with buying a vacation home with their retirement funds. When you buy a vacation home, you can't stay in it yourself: You can only rent it out or sell it for a gain. If you try to use the property in any other way, it could become a prohibited transaction.
Another problem that people may run into with self-directed IRAs and real estate is borrowing money. For example, you might have enough money in your retirement account to come up with the down payment for a piece of property, but you may have to borrow the money for the rest of the purchase. If you do this, you have to ensure that you don't put any of your personal funds in with the loan. If you comingle funds, it's a prohibited transaction.
If you're found guilty of engaging in a prohibited transaction, you have to pay a penalty to the Internal Revenue Service. As soon as prohibited transaction is discovered, you have to pay a 15 percent tax on the transaction for each year that you were involved in it. If you don't take the necessary steps to fix the problem, you have to pay a 100 percent tax on the transaction.