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The 7 Downsides of Using a Self-Directed IRA for Buying Rentals

Dec. 27 Blog SDIRAs

Summary: Self-directed IRAs (SDIRAs) may seem like an attractive option for buying rental properties but there are many downsides to using a SDIRA. In this article, we cover the many downsides.


In most cases, investing in cashflowing rentals requires that you have money for a down payment. 

(I say “in most cases” because there are some ways to buy rentals with little or no money down, but we’re not covering those in this article.)

To come up with funds for a down payment, many people look to their retirement accounts. 

There are several ways you can tap your retirement funds for this purpose.

One option is to simply liquidate your retirement account, which is something we’ve done. While it’s not for everyone, we explain why we chose to liquidate our retirement accounts HERE.

A second option is to borrow from your retirement accounts. In some cases you can borrow as much as $50,000 to use as a down payment on a rental property. This is considered a loan, so one of the downsides of this approach is that you have to pay the loan back within a certain period of time, usually 5 years. 

The third option is to use something called a self-directed IRA (SDIRA). On the surface, this one seems like the best option because you aren’t taking money out of the IRA. This means there’s no penalty like you have in the first option, and you don’t have to pay it back like you do in the second option.

Sounds pretty good, right? Which is why we frequently encounter the question: are there any downsides to using self-directed IRA funds to buy rental properties?

And the answer is YES! 


SDIRA Downside #1: Annual fees

If you’re a stock investor, you’re familiar with the downsides of fees and how they eat up your returns.

It’s no different with a SDIRA.

IRS rules require that your SDIRA have a custodian and custodian fees are charged annually. They can be a flat fee or based on asset value so the range of fees is quite large. 

Doing some quick online searches reveals that you can get fees as low as $100-300 annually, although I didn’t check to see if these were reputable providers or if they had the proper certification. If you’re considering this option, I recommend doing that research as well. 

Regardless of the actual cost, just know that there are fees and every dollar of fees lowers your overall return. 


SDIRA Downside #2: You can’t use the cashflow

One of the primary benefits of cashflowing rentals is that it puts cash in your pocket each month. In brief, we believe that having your rentals generate cashflow is a MUST when you invest in rental properties. Otherwise, your rental is a liability, not an asset.

The beauty of getting cashflow from your properties is how it can help with unexpected, costly situations. If you have an unexpected repair at one of your properties, you have cash that can cover the cost. Or maybe something happens and you can no longer work. The cashflow can be a savior in this situation because you can live off the cash. 

What about the cashflow from a rental property you buy using a SDIRA? Can you use it to live on in an emergency? Nope. Just like money in your retirement accounts, the money is in jail and doesn’t get out of jail until you’re 59 and a half. 


SDIRA Downside #3: You can’t take advantage of depreciation

Depreciation is one of the main benefits of investing in cashflowing rentals. It’s what allows you to get cashflow from a property and at the same time, show a loss on your tax returns. 

This means that your cashflow is often tax-free. 

So let’s say you make $100,000 in cashflow from your properties. Because of depreciation, you probably won’t pay a penny of taxes on this amount. So this is equivalent to making $125,000 of W2 income assuming a 25% effective tax rate. 

With a rental locked up in a SDIRA, depreciation is irrelevant because you never see the cash anyway. So you miss out on one of the greatest benefits of investing in cashflowing rentals.


SDIRA Downside #4: You can’t generate paper losses and use it to shelter income

Important note: you need to qualify for Real Estate Professional Status (REPS) in order to get this benefit.

One of the components of our Fast Fire Strategy is to generate massive paper losses and use these losses to shelter W2 or 1099 income. 

Now these are paper losses, not real ones, so we are still generating significant cashflow from our properties. At the same time, we’re paying zero income taxes because the paper losses are offsetting our W2 or 1099 income. 

The issue with your rental in an SDIRA is that any losses stay in the SDIRA and can’t be used to offset your W2 or 1099 income.


SDIRA Downside #5: Forced distributions

If you have your property in a SDIRA, at a certain age, you are required to take distributions and those distributions are taxed at a higher rate (regular income tax rate rather than capital gains rate). 

The required distribution is based on a portion of the appraised value of the property. In order to determine this value, you have to pay for an appraisal each year. 

The other problem is that your rentals are not liquid, so if your entire SDIRA is invested in rentals, you’d have to figure out how to pay out the required distributions. 


Downside #6: No step-up in basis

For those pursuing generational wealth and planning to pass along their real estate portfolio to their children, one of the benefits of owning rentals is that your children get something called a “step-up in basis.” 

In a nutshell, this means your children don’t have to pay for the taxes you owe. They inherit the property at the current value of the property when you die, not what it was worth when you bought it. 

This is a huge benefit for your children and a way to create generational wealth. 


Downside #7: You might have to pay taxes on the income

This one is a real downer.

The whole point of the SDIRA is to grow your wealth tax-deferred, not to pay taxes along the way. 

Well, this might just happen if you buy a rental property using a mortgage. 

This is something called Unrelated Business Taxable Income or UBTI. Sounds unpleasant just reading those words. 

One of the advantages of buying a rental property using a mortgage is the power of leverage. It’s using other people’s money to grow your wealth. 

You can still use leverage with a SDIRA but the UBTI tax really is a party pooper! 


So…should you use an SDIRA, or not?

I know some people love the idea of buying a rental with their SDIRA, but if you do so, be sure to read through the many downsides. It might just make you want to leave it to the professionals rather than trying to “self-direct” it!


Do you want to learn how to creatively fund your real estate portfolio and achieve financial freedom? Join the conversation! Follow our Semi-Retired MD  Facebook page and join our Doctors or Professionals  group!

Semi-Retired M.D. and its owners, presenters, and employees are not in the business of providing personal, financial, tax, legal or investment advice and specifically disclaims any liability, loss or risk, which is incurred as a consequence, either directly or indirectly, by the use of any of the information contained in this blog. Semi-Retired M.D., its website, this blog and any online tools, if any, do NOT provide ANY legal, accounting, securities, investment, tax or other professional services advice and are not intended to be a substitute for meeting with professional advisors. If legal advice or other expert assistance is required, the services of competent, licensed and certified professionals should be sought. In addition, Semi-Retired M.D. does not endorse ANY specific investments, investment strategies, advisors, or financial service firms.


Hi, we’re Kenji and Leti

we provide coaching and mentorship for doctors and high-income earners

Several years ago, we were newlyweds working as full-time hospitalists. On paper, it looked like we had everything: the prestigious careers, the happy marriage, the luxurious rental home, the cars, etc.

But in reality? Despite having worked for several years, we had very little savings. Despite our high income, we had very little freedom in terms of time or money.

One thing was clear: we had to do something.

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