For self-directed investors, it is commonly considered “real estate investing 101” to believe that it is crucial to round out your retirement portfolio with some real estate investments and real estate-related assets. However, when you invest in real estate using your self-directed IRA or 401(k), there are some common mistakes that even many experienced investors make. In this Mainstar Trust Primer, we have assembled the three most common real estate investing mistakes that self-directed investors make and, shockingly, that many self-directed “educators” recommend.
Real Estate Investing 101 - Mistake #1: Prohibited Transactions
Of course, the top of the list must be prohibited transactions. Prohibited transactions occur when a self-directed investor benefits in some way prior to retirement from their self-directed retirement account. Examples of prohibited transactions include using self-directed account assets for personal benefit (for example, buying a vacation home as an Airbnb and then staying there yourself) and employing yourself or a relative to work on or in your properties. Although there are strategies that might enable you to pay yourself or another disqualified person for property management of properties in your self-directed account, these strategies are risky and often do not work out well for self-directed investors.
Investor Action Item: Learn everything you can about prohibited transactions, then consult with your trusted IRA or 401(k) advisor before implementing creative strategies.
Real Estate Investing 101 - Mistake #2: Owning Taxes is the End of the World
In some cases, you may find that you owe a portion of the profits from a deal you did in your self-directed IRA or 401(k) in taxes. This is most often a result of your self-directed account engaging in an active business transaction, such as flipping or wholesaling. It can also result from using leverage in a real estate transaction conducted through your self-directed account. These real estate investment strategies can be great ways to build up capital or maximize the profits from your investment capital, and, within moderation, are legitimate ways to use your self-directed account. However, it is important to figure out, in advance, how much you might owe as a result of using these strategies and then to pay in full once the transaction is completed. Also, most IRA experts recommend against doing high volumes of transactions that result in unrelated business income tax (UBTI), so consult a trusted advisor prior to getting started.
The important thing to realize is that owing taxes in your self-directed account is not the end of the world as long as they are paid. Taxes are not equivalent to prohibited transactions no matter how much you would like to avoid both!
Real Estate Investing 101 - Mistake #3: If One Investor Does It, We All Can
Probably one of the biggest mistakes real estate investors make about self-directed investing is that they believe that the real estate investing community, as a whole, may be used as guidance for self-directed investment strategies. Real estate investors tend to be highly creative and innovative, which is great. They also tend to function in communities, such as masterminds, in extremely effective and generous ways, sharing information and strategies willingly and proudly. This is all positive, but when it comes to self-directed investing it can be a major pitfall. You must remember two things about creative self-directed investment strategies:
Just because someone hasn't heard from the IRS does not mean that their strategy worked.
Remember, if you commit a prohibited transaction and distribute your self-directed account’s assets, that event does not have to come to light immediately, next month, or even next year to ultimately result in big problems for your self-directed retirement account. When the IRS discovers a prohibited transaction or conducts an audit of your retirement account, they can go (and will) go all the way back to the beginning of your account. The point at which the prohibited transaction occurred is the point at which they will begin adding on fees, fines, and penalties for that transaction, and everything done after that will not receive the tax protections and advantages normally associated with self-directed account assets.
Bragging about "beating" the IRS is like waving a red flag in front of a bull.
Sadly, there are many cases where an investor comes up with what they believe to be a “foolproof” way to work around self-directed IRA or 401(k) regulations and, after bragging about this strategy publicly, they find themselves in the middle of an audit that will not end well. Are there instances in which self-directed investors commit prohibited transactions or create complicated systems of businesses within their self-directed accounts that seem to successfully permit them to “have their cake and eat it too?” Sure. But, as we have just discussed, not getting caught yet does not negate the ramifications of committing the prohibited transaction, and handing out advice to others about how to “beat” the IRS generally is bad policy when it comes to avoiding negative attention yourself.
Invest in Real Estate Education as an Asset
One of the best investments a self-directed investor will ever make is in their own education. While it is important not to permit yourself to get bogged down in “research” to the point where you never actually acquire any assets for your self-directed retirement account, never hesitate to consult a trusted professional and expert prior to making a real estate investing move. The time and money you will save yourself by getting information and advice upfront will more than make up for the expense of investing in your real estate education.
Please note: Not all alternative investments require Accredited Investor status. Please review the private placement memorandum, subscription agreement, or prospectus for purchase.
Always take the time to consult with trusted, professional advisors to ensure you understand tax, legal, and investment issues related to the use of IRA funds in LLCs.