Should You Use Your 401(k) or IRA to Invest in Real Estate?

(Adam Levy)

Investing in real estate can be a great way to build wealth while diversifying a portfolio of stocks, bonds, and other securities. But if you’re thinking of using your 401(k) or IRA as the vehicle in which you make real estate investments, you need to consider what you gain and what you give up by doing so.

There are many ways to invest in real estate. Sometimes keeping those investments in a retirement account works great, but sometimes it’s a big mistake.

Avoid buying physical properties directly

You can use a self-directed IRA or 401(k) to buy physical property, but it’s probably not a good idea. That’s because there are a couple of great benefits to investing in rental properties that are somewhat limited when you own them in a retirement account.

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The first benefit is cash flow. A good real estate investment will produce positive cash flow for you most months. Unless you have a major repair or long vacancy, you’ll find a steady stream of rent checks that more than offsets your expenses.

You can use that cash flow to invest in more rentals or buy assets like stocks and bonds. You can also use that cash to finance your lifestyle, pay for necessities, or anything else you want. If you invest in a rental property in your retirement account, you will limit your options for that cash flow. You will have to roll it over into something unless you have reached the age where you can withdraw funds without penalty.

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The second benefit is the tax efficiency of rental properties. You can offset your income with many expenses. That includes mortgage interest paid and property depreciation (even if the value is appreciating in real life). If you use a tax-deferred retirement account, you won’t pay any taxes until you withdraw the funds, but you also won’t take advantage of some of the tax breaks. Therefore, you could end up paying more taxes in the long run as a result.

Other things to consider

Also, another benefit of investing in physical real estate is that you can move into the property if you wish. If you had the property in a 401(k), that would be prohibited. That also means you won’t be able to qualify for a lower interest rate offered to people who buy a primary residence. Also, you won’t be able to move into the property for two years before its sale to reduce the property’s capital gains tax, if you want to pursue that strategy.

Not being able to live in the property in your 401(k) or IRA also means that investment strategies like home investing don’t work. Again, the big benefit of that investment strategy is minimizing your tax bill, so you won’t be taking full advantage of the retirement account benefits.

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Two Great Ways to Invest in Real Estate in Your Retirement Accounts

That said, there are a couple of ways to get exposure to the real estate market that are better suited for retirement accounts. That’s because they don’t come with the tax benefits of directly buying physical real estate and renting it out.

If you’re looking for exposure to individual real estate investments, you can write private notes on your self-directed IRA or 401(k) for other investors. For example, someone investing in a rehab project may not be able to get a traditional mortgage on their fixer-upper. You may be able to generate very good returns by offering to lend some of the money in your retirement account to investors you know and trust.

The advantage of doing this in an IRA or 401(k) is that you can defer income tax on the interest charged on those notes. Unlike investing in a property directly, there are no ways to offset any gains.

You can also invest in REITs in a 401(k) or IRA. A REIT is required to pay 90% of its taxable income as a dividend to shareholders. Those earnings are passed on to shareholders, so they typically don’t get the lowest qualified dividend tax rate; investors have to pay their regular income tax rate on them. Having a REIT in a retirement account allows you to defer taxes, save more money for short-term investing, and control your tax rate in retirement.

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If you want real estate exposure in your retirement accounts, the best way to do this is by using income-producing assets without preferential tax treatment. Investing in physical real estate is best suited outside of your retirement accounts, where you can take full advantage of tax advantages and cash flow.

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