Why You NEVER Own Real Estate in a Self-Directed IRA

Ever glance at your IRA and think, ‘There’s got to be a more exciting way to grow this’? Beyond the familiar world of stocks, bonds, and mutual funds lies a realm of alternative investments, full of potential and pitfalls. Imagine channeling your IRA into a bustling local startup or even that beachfront property you’ve always admired.

It seems that by putting “better” investments into your IRA, you could gain a better return and thus a better retirement.
Most custodians that are going to hold your IRA account are going to limit your investment choices to those mutual funds, stocks, and bonds. There are a few custodians out there that will open a self-directed IRA on your behalf.

With a self-directed IRA, you are given many more investment options. Options to invest into businesses, limited partnerships, and even directly into real estate. Now, just because you are given these options doesn’t mean that you should rush out and make those investments. There are a few caveats that you need to be aware of before making alternative investments with your IRA. The IRS has set very strict rules that are incredibly easy to break.

Dive in with me, and let’s explore the intriguing world of self-directed IRAs and discover if they could be the key to unlocking your financial future.

What is a Self-Directed IRA?

Most custodians will allow you to open a Traditional IRA that holds very simple and easy-to-own investments. These investments can be in stocks, bonds, mutual funds, and exchange-traded funds. For the investor and the custodian, this is an easy process that doesn’t require a lot of oversight. In fact, rarely are any of these transactions prohibited, so the chance of messing up is slim.

Big box custodians don’t want to take on the extra work of managing investments outside of these more standard investments, nor do they need to. This, in turn, has opened the door for companies to come in and specialize in IRAs with alternative investments.

Companies such as Equity Trust, Pensco, and Entrust Group all offer the option of a self-directed IRA.

The self-directed IRA is still a Traditional IRA. The account is funded with pretax money, and the money withdrawn will be taxed at ordinary income rates. If you withdraw money before the age of 59 ½, there will be penalties.

These companies allow you to invest your IRA funds into alternative investments. Alternative investments include limited partnerships, small businesses, and investments directly into real estate. Investing in real estate with your IRA became very popular in the 2000’s real estate boom.

There are some investments that are still prohibited. Investments such as life insurance, collectibles (minus some precious metals), and S corporations are all still prohibited from being owned by an IRA account.

The real trap in using a self-directed IRA is that it is up to you, the account owner, to make sure that you don’t break any rules. Most people believe that the IRA custodian would stop them from breaking the law and placing their IRA in jeopardy, but that is not true. An IRA custodian may stop some of the bigger rule breaks, such as letting you invest in life insurance, but they will not monitor what you do with your money outside of that. There are multiple ways to break the rules by making alternative investments with your IRA.

Beware of Disqualified Persons

The first thing you must understand when making alternative investments with your IRA is who you can and cannot do business with. If you are investing in normal mutual funds, stocks, and bonds, then you do not need to worry about this.

The IRS stipulates that your IRA cannot benefit you or any related parties outside of the IRA. A disqualified person includes the fiduciary to the account, which includes the IRA owner, any member of the family, a corporation, partnership, trust, or estate where 50% or more interest is owned by you or a related person, or an officer, director, or 10% or more shareholder of any entity described above.

Basically, if you or your family will benefit at all from your IRA investment, then it is prohibited. You cannot use your IRA to invest in your brother’s business. Your brother would gain from that transaction, so it is prohibited. You cannot invest in a business that you own because you will have gained from it.

If you are investing in real estate, you cannot rent, sell, or give away for free any part of the property to yourself or anyone related.

What happens when you do break the rules and transact with a disqualified person?

The IRS will levy a penalty on the amount involved in the transaction. The initial tax on the prohibited transaction is 15% of the amount involved for each year. If the transaction has not been corrected within the year that that IRS levies this penalty, then it jumps to 100%. If more than one person was involved in the transaction, all parties could face the penalty. As you can see, the penalty is steep for doing transactions with a disqualified person. If you go down this route, it is best to make sure that nobody you know will be on the other end of your IRA transaction. The worst news is that this penalty is not as severe as the IRS gets with IRA transactions.

Beware of Disqualified Transactions

Now that you understand you cannot make investments with your IRA that involve you or someone you’re related to, there are transactions that you must be careful of too.

You cannot sell, exchange, or lease property to a disqualified person. It doesn’t matter if the sale, exchange, or lease is done for a profit, loss, or at fair market value. If you sell a house to yourself, rent a room to your child, or give your mother a piece of land that is owned by your IRA, then this is a prohibited transaction.

You cannot lend money or extend credit to or from your IRA to any disqualified person. Again, it doesn’t matter if this ends up being a gain, loss, or wash transaction.

You cannot furnish goods, services, or facilities with any disqualified person, nor can you transfer, use, benefit, or deal assets from your IRA that benefits a disqualified person.

The penalty for this type of transaction is a lot more severe. The IRS will treat the complete IRA as disqualified. The entire IRA is treated as a distribution, and normal penalties and taxes with be assessed on the distribution.

You have a $1 million IRA, and with it, you use $200,000 to invest in a house. You decide to rent that house to your brother at fair market value. Once the IRS finds out, they will deem this as a prohibited transaction with a disqualified person. They will tell you that the entire $1 million IRA is being treated as a distribution. If you are under the age of 59 ½, you will be assessed a 10% penalty ($100,000) and you will have to include the $1 million as income and pay ordinary income tax on it. That is a steep penalty.

The Risky Business of Real Estate in an IRA

You may be thinking that you could take this chance and just not let your IRA benefit a disqualified person. After all, how difficult could it be to not rent, sell, or lease to a family member?

It seems easy enough.

Don’t forget that a disqualified person also includes yourself, and a prohibited transaction includes the rendering of goods, services, and the transfer or use of the asset. This means that if you walk into your rental house and change out the burned-out light bulb, you have rendered a service to that property. This has now become a disqualified transaction benefiting a disqualified person.

If you own a piece of land that has a pond on it and your family wants to go fish in that pond, you have just committed a prohibited transaction.

Basically, if you want your IRA to own real estate, you or anyone related to you cannot set foot on the land, ever.

You must hire everything to be done, and you must pay for the expenses from the IRA. You cannot pay for the expenses out of your own pocket. Any income received from the property must be paid directly to the IRA. If you were to place the income in your own bank account before moving it to the IRA, you have commingled funds, and this is prohibited.

How to Venture into Self-Directed IRAs

  1. Choose the Right Custodian
    • Investigate potential custodians that specialize in self-directed IRAs, such as Equity Trust, Pensco, and Entrust Group.
    • Compare their fees, services, and customer reviews.
  2. Understand the Rules
    • Familiarize yourself with the IRS’ regulations regarding self-directed IRAs. Particularly pay attention to prohibited transactions and disqualified persons.
    • Regularly check for updates or changes in the rules.
  3. Diversify Your Investments
    • Avoid placing all your funds in one type of alternative investment.
    • Consider a mix of real estate, limited partnerships, and small businesses.
  4. Stay Vigilant with Real Estate Investments
    • If you’re considering real estate, understand the strict regulations around it, especially if considering renting out or using the property.
    • Always manage expenses, income, and any maintenance using only IRA funds.
  5. Regularly Review and Adjust
    • Periodically review your investments to ensure they align with your financial goals.
    • Adjust your portfolio based on market conditions, personal financial situation, and any change in goals.
  6. Stay Educated on Prohibited Transactions
    • Make it a point to periodically review the list of prohibited transactions to ensure you don’t inadvertently violate any rules.
  7. Keep Detailed Records
    • Maintain meticulous records of every transaction, communication, and decision related to your self-directed IRA.
    • This will be invaluable if there are ever any questions or concerns about your investments.
  8. Re-evaluate Annually
    • At least once a year, sit down with your financial advisor to assess the performance of your self-directed IRA investments.
    • Make any necessary changes based on this evaluation.


In the tapestry of investment opportunities, self-directed IRAs stand out as both a tantalizing prospect and a complex puzzle. While they offer a chance to venture beyond the conventional and dip our toes into diverse investment waters, the undercurrents can be deceptive. From real estate dealings to start-up investments, the allure is undeniable. But remember, every choice carries consequences, and in the realm of financial futures, the stakes are high. Tread thoughtfully, armed with knowledge and perhaps the guidance of financial experts. After all, the journey to prosperity is not just about taking risks but taking informed, calculated ones.


IRA (Individual Retirement Account): A tax-advantaged account that individuals use to save and invest for retirement.
Mutual Funds: An investment vehicle made up of a pool of funds collected from many investors for the purpose of investing in securities such as stocks, bonds, and other assets.
Custodian: An institution responsible for holding and safeguarding a firm’s or an individual’s financial assets.
Self-Directed IRA: An IRA that allows the owner to have a broader range of investment options, such as real estate or private company stock.
Traditional IRA: An IRA that allows individuals to direct pre-tax income, up to specific annual limits, toward investments that can grow tax-deferred.
Alternative Investments: Assets that are not one of the conventional investment types, such as stocks or bonds. Examples include real estate and private equity.
Disqualified Persons: Individuals or entities with whom your IRA cannot engage in transactions. This includes the IRA owner, certain family members, and business entities in which they have significant control or interest.
Prohibited Transaction: Transactions that an IRA cannot engage in without facing penalties. These can involve certain dealings with disqualified persons or certain types of investments.
Distribution: The withdrawal of assets from a retirement account.
Commingling Funds: Mixing IRA funds with personal funds, which is not allowed in self-directed IRAs.
Fiduciary: A person or entity that has the responsibility to act in the best interests of another person or entity, often in relation to financial matters.