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

(Adam Levy)

Investing in real estate can be a great path to building wealth by diversifying a portfolio of stocks, bonds and other stocks. But if you are considering using your 401 (k) or IRA as a vehicle in which you invest in real estate, you need to consider what you earn 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 that’s probably not a good idea. This is 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 for most months. Unless you have a major repair or extended vacancy, you will find a steady stream of rent checks coming in that more than make up for your expenses.

You can use that cash flow to invest in multiple rents or buy assets like stocks and bonds. You could also use that money to finance your lifestyle, pay for your needs, or whatever you want. If you invest in a rental property in your retirement account, you will limit your options for that cash flow. You will need to reinvest it in something unless you have reached the age where you can withdraw funds without penalty.

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The second advantage is the tax efficiency of rental properties. You can offset your income with a lot of expenses. This includes mortgage interest paid and depreciation of the property (even if the value is appreciating in real life). If you use a deferred retirement account, you won’t pay any fees until you go to withdraw funds, but you won’t be able to take advantage of some tax breaks either. As a result, you may end up paying more fees in the long run.

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 owned the property in a 401 (k), it would be prohibited. This also means that you will not be able to benefit from a lower interest rate offered to people purchasing a primary residence. Additionally, you will not be able to move into the property for two years prior to its sale to reduce the capital gains tax on the property if you wish to pursue that strategy.

The inability to live on the property held in your 401 (k) or IRA also means that investment strategies like the live-in flip don’t work. Again, the great advantage of such an investment strategy is to minimize the tax bill, so as not to take full advantage of the benefits of the retirement account.

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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 gain exposure to the housing market that are best suited for retirement accounts. This is because they do not have the tax benefits of direct physical property purchase and rental.

If you are looking for exposure to individual real estate investments, you can write private notes from your self-directed IRA or 401 (k) to other investors. For example, someone who invests in a rehabilitation project may not be able to get a traditional mortgage for their repairman. You may be able to generate excellent returns by offering to lend some of the money in your retirement account to investors you know and trust.

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

Similarly, you can invest in REITs in a 401 (k) or IRA. A REIT is required to pay shareholders 90% of its taxable income as a dividend. Those profits are passed on to shareholders, so they typically do not get the lower qualifying dividend tax rate; investors must pay their normal rate of income tax on them. Keeping a REIT in a retirement account allows you to defer taxes, save more money to invest in the short term, and control your retirement tax rate.

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If you want exposure to real estate in your retirement accounts, the best way to do this is to use income-generating assets without preferential tax treatment. Investing in physical real estate is best suited outside of your retirement accounts, where you can make the most of the tax benefits and cash flow.

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