When Does Using a Self-Directed IRA to Invest in Real Estate Syndication Make Sense?

If you’re new to the world of private real estate investing, you may not know you can invest in real estate syndication and other private investments through a Self-Directed IRA (SDIRA). If you’ve been around private real estate for a while, you probably already know this is possible.

Either way, the question is, should you invest in real estate syndication using a self-directed IRA?

We’ll discuss that in this article, as well as my personal experience with SDIRAs, but first lets cover some SDIRA basics.

SDIRA Basics

How SDIRAs Work

Typically all you need to do to invest through a SDIRA is:

1. Choose a SDIRA custodian
2. Open the SDIRA account
3. Fund the account by either:
   • Rolling over funds from an existing IRA; and/or
   • Rolling over funds from an old 401(k) from a previous employer; and/or
   • Funding the account with cash ($6,000 limit in 2019)
4. Choose an investment
5. Instruct the SDIRA custodian to fund the investment.

Things to Consider When Using a SDIRA

Fees

SDIRA accounts charge fees. Fees vary from custodian to custodian but typically include:

• Set-up fee: $50
• Annual fee: $205 – $2,150
• Check/wire fees: $25-$30
• Termination fee: $100 – $225

The Unrelated Business Income Tax (UBIT)

We’re not going to go into an in-depth discussion of UBIT here. However, you should be aware that investing in real estate syndication offerings through a SDIRA isn’t always 100% tax free.

When you invest in a real estate syndication that uses debt financing (i.e. a mortgage) through a SDIRA, the portion of income attributable to debt financing is called Unrelated Debt Financed Income (UDFI). Here’s a simplified example, if you invest $100,000 into a syndication that finances the property with 75% debt, and generates $10,000 net income, then $7,500 is considered UDFI.

The good is in most cases, you’ll have losses caused by depreciation, which helps you avoid UBIT over the holding period of the investment. The point where most investors face UBIT is when a capital gain is generated upon liquidation of the investment. And because almost all real estate syndicates use debt financing, this is something that you’re likely to deal with when investing through an SDIRA.

When It DOESN’T it Make Sense to Use a SDIRA to Invest in Real Estate Syndication

When you can invest in cash instead.

Avoiding SDIRA fees, UBIT, and administrative hassles aren’t the only reason to make the investment with cash if its available. You’ll also have to remember that real estate is already a taxed advantaged investment.

Better to leave your IRAs (and other retirement accounts) in stocks, bonds, and other traditional investments because these investments can grow tax free within the account. Whereas with real estate, depreciation often shelters the rental income from tax. In addition, there are plenty of other strategies you can use to defer, reduce, or even potentially eliminate, the capital gains tax on sale of the real estate investment if you don’t have enough current and/or suspended losses to do that already.

For this reason alone some investors never put real estate in a SDIRA account. But as in most cases, it all depends on your specific circumstances (e.g. available capital, time horizon, current asset allocation, etc.).

When it DOES it Make Sense to Use a SDIRA to Invest in Real Estate Syndication

It appears to make sense to use a SDIRA to invest in real estate syndication when pretty much all of your investable capital is in IRA or other retirement accounts, making a cash investment not possible.

If this sounds like you, then you likely have tens, if not hundreds of thousands of dollars in stocks, bonds, and mutual funds through you’re retirement account, and are looking for diversity in assets that don’t directly correlate with the financial markets.

In this situation it makes sense to use a SDIRA to invest in real estate in order to diversify your portfolio. Better to deal with SDIRA fees and UBIT then to liquidate part of the IRA, pay a 10% early withdrawal penalty and potentially federal/state income tax on a portion or your total distribution just to invest with cash. This is because the penalties and taxes can easily eat up 50% or more of the money in your IRA, greatly reducing the principal you have to invest

My Experience Using SDIRA to Invest In Syndication

A few years back I opened a SDIRA and invested $10,406 from an existing IRA. I used it to invest in a syndication that recently liquidated. While the investment earned roughly an 11.5% return over two years when you factor in distributions, the realized gain was $2,117 and the partnership withheld $885 in taxes, which represents 41.8% of the return.

Not only is this more than the amount of UBIT I owe the IRS, it reduces my return to 5.9% per year. Of course my SDIRA should receive part of this withheld amount back after tax returns are filed, but its going to be a hassle to make sure that actually happens. And I haven’t even touched on fees charged by the SDIRA company over the time I held this investment, which I’m not even going to look into, just know that when you factor in fees, it eats into the returns even more.

My take away from this was that until I have hundreds of thousands in my retirement accounts, I’m not even going to consider making another real estate investment through a SDIRA. Instead, I’m rolling my SDIRA funds back into my Vanguard Roth IRA where the rest of my IRA funds are in low-cost index funds. I know I said I wasn’t going to look into fees, but I’ll say this, the SDIRA company charges $150 to transfer the funds back to Vanguard.

The good news is, this was a relatively inexpensive lesson.

Summary of what I learned:

• UBIT reduces your return when a property that uses leverage is liquidates.
  • It eats into them even more when if you consider the withholding amount. Plus the hassle of making sure the remainder of the withholding finds its way back into my IRA
• Fees further reduce the returns, plus I have to pay $150 to transfer my money out of the SDIRA account, which in and of itself is a hassle to do.
• When the money is sitting idle between investments or when waiting to be transferred (its taking about 2-4 weeks to complete the transfer) I’m losing out on the time this money could be working for me.
• I’m better off leaving this money in low-cost index funds and letting it compound overtime.
  • I’ll likely much all my future syndication investments in cash going forward.

The Bottom Line

After you factor in the fees SDIRA companies charge to open and maintain an account, UBIT and withholding, returns lost to money sitting idle, and the overall hassle of dealing with a SDIRA, it begs the question when does using one make sense?

And, at least based on my experience, that likely only make sense when you have hundreds of thousands invested in traditional assets in your retirement accounts, and have no other source of investable funds to diversify your portfolio into assets not directly correlated to the financial markets.