Self-Directed IRA Real Estate: Understanding the Tax Benefits and Compliance Traps

During a recent Real Estate Industry Update, Daniel Roccanti and Kyle Paxton from James Moore & Co. shared critical insights on using self-directed IRAs for real estate investments. The discussion revealed how these accounts can offer powerful tax advantages while also exposing investors to severe penalties if IRS compliance rules aren’t followed precisely. This conversation highlighted why understanding the difference between standard real estate investing and self-directed IRA real estate investing is essential for protecting your retirement savings.

What Makes Self-Directed IRAs Different from Standard IRAs

Self-directed IRAs aren’t a special type of retirement account created by unique legislation. As Roccanti explained, “It’s just an IRA. Standard IRA rules, but there’s just one big thing that’s different and that is considered self-directed because you have more abilities to basically invest in things.”

Traditional custodians like Vanguard and Fidelity limit investment options to prevent account holders from making costly mistakes. However, specialized custodians allow self-directed IRAs to invest in real estate, private companies, limited partnerships and precious metals. This expanded control comes with expanded risk.

Paxton emphasized an important distinction: “The IRA itself is the owner of the investment. It’s separated from Kyle Paxton personally. Kyle Paxton is not an owner. It is Kyle Paxton’s IRA that owns this investment. That distinction is very important.”

Three Ways to Structure Self-Directed IRA Real Estate Investments

Investors can structure their self-directed IRA real estate investments in three primary ways:

Direct Ownership

The IRA owns the real estate directly. This is the simplest structure with fewer moving parts, but execution can be slower because the custodian must be involved in every transaction.

IRA-Owned LLC

This is the most common structure for direct real estate investing. The IRA owns an LLC, which then owns the real estate. This provides “checkbook control” allowing faster deal execution and easier vendor payments. However, as Roccanti noted, “there’s also issues here because now again I’m putting more of that risk back on me where I’m going to be non-compliant.”

Passive Syndication Investments

The IRA invests in a real estate fund as a limited partner. While this structure is more passive, it can create unexpected tax reporting requirements if the fund uses leverage.

The Severe Consequences of Prohibited Transactions

The penalty for making a prohibited transaction is severe. Roccanti explained: “The IRA ceases to be an IRA on the first day of that year, that taxable year. So, January 1st, it’s no longer an IRA. And then the fair market value of your IRA is distributed to you to the account owner and the beneficiary. So that has to be included in your income.”

One mistake wipes out the entire IRA, triggering immediate taxation, penalties and interest on the full account value.

Prohibited Transaction #1: Dealing with Disqualified Persons

You cannot buy property from or sell property to yourself, family members or other disqualified persons. Roccanti stated clearly: “I can’t buy my own property. I can’t sell my own property. Can’t buy my family members properties or sell it to my family members. That’s all prohibited transaction.”

This extends to lending arrangements as well. You cannot lend money to your IRA or borrow from it. Your relatives cannot engage in these transactions either.

Prohibited Transaction #2: Personal Use of IRA-Owned Property

Any personal benefit from self-directed IRA real estate is prohibited. Paxton explained: “Personal use of the actual real estate. So the easy example here is a vacation home, right? You got that beautiful beach house you want to acquire and you’d love to spend just a weekend, you know, nothing nothing too crazy there. That in itself, a quick stay, storing personal items, letting other family use the property can blow the investment.”

Even storing equipment or allowing family members to use the property constitutes a prohibited transaction. As Roccanti emphasized: “If you’re considering personal use, you’re not doing it in your IRA. You need to buy it personally. You need to structure it a different way. IRAs are strictly for investment.”

Prohibited Transaction #3: Self-Dealing and Sweat Equity

Real estate investors typically want hands-on control of their properties. This instinct becomes a compliance trap with self-directed IRA real estate.

Roccanti explained: “Your labor, your actions are being basically seen as a benefit to the account as a benefit to you. You’re self-dealing. You or any of your related party or disqualified people cannot provide services to the property. They can’t pay for things. The IRA has to.”

This means no repairs, no property management and no paying expenses personally. Paxton added: “Any personal use of actually benefiting from the real estate yourself or performing activities that increase the value of the real estate, you know, personally can jeopardize these investments.”

You must use third-party property managers and independent contractors. As Roccanti put it: “Think less me more third party contractors. I am the oversight. I’m the highest level possible. I can’t do any of the work.”

The Hidden Tax Trap: UBIT and UDFI

When self-directed IRA real estate investments use leverage, they can trigger unexpected tax reporting requirements.

Roccanti explained the surprise many investors face: “I thought this was going to be tax exempt. I didn’t think I had to do it. Now I’ve just created by investing in real estate using leverage. I actually now have to go back to filing a tax return.”

The IRA must file Form 990-T to report unrelated business income tax (UBIT) or unrelated debt-financed income (UDFI). The filing threshold is only $1,000 of taxable income.

This becomes particularly problematic with syndication investments. As Roccanti noted: “If you invest in these syndications these funds, you don’t have control. If they go use leverage they just created a taxable situation. When you get that K1 now I have to report it. Now I have to do the 990-T.”

Paxton added: “That filing threshold is low. So, you have probably $1,000 of taxable income allocated to you, the reporting requirement kicks in.”

Plan for Liquidity Needs

Self-directed IRA real estate creates liquidity challenges because all expenses must be paid from the IRA itself. Paxton stressed: “The IRA has to make sure you have the cash reserve for the expenses, ongoing expenses both the IRA itself and any fees that you need to pay to the custodian, taxes on the real estate, repair maintenance.”

The liquidity problem intensifies at age 73 when required minimum distributions (RMDs) begin. Without cash in the IRA, investors may be forced to take loans, which triggers the UBIT tax reporting requirements.

Roccanti emphasized: “If you don’t have enough money in the IRA, now I got to get a loan, which then creates tax compliance because now I have unrelated business income tax. So, you can see how it can easily go wrong.”

Make Self-Directed IRA Real Estate Work

Despite these challenges, self-directed IRA real estate can be effective when structured correctly. Paxton concluded: “These are great ways to invest in real estate and it’s another tool in our toolbox. It really gets back to making sure you do the intentional planning and set these things up correctly for them to be successful.”

Roccanti agreed but cautioned: “Make sure you understand the rules and understand that it’s going to go against what your nature is of how you’ve done real estate before. Just make sure you understand the rules, make sure you understand that you’re not doing prohibited transactions. You’re documenting. You’re using more third parties to do everything.”

Take the Next Step with Professional Guidance

Self-directed IRA real estate investments require coordination between your entire advisory team including CPAs, attorneys and wealth managers. The tax benefits can be substantial, but the compliance requirements are unforgiving.

Ready to learn more about using your IRA to buy real estate? Click here to watch the full episode where Daniel Roccanti and Kyle Paxton cover every critical compliance rule you need to know before investing retirement funds in real estate.