Q: I have been contributing to a pre‑tax 401(k) for many years, and a Roth IRA as well. I’m 52 and very disappointed in the balance of these accounts, as many people are these days.

My question is: is it good time to roll these funds over to a self‑directed IRA and buy investment real estate with the money in that account? I read that a few cities have seen an upturn in real estate over the past few months.

A: Under IRS guidelines, you are certainly permitted to use a self-directed IRA to invest in real estate, but doing so isn’t as simple as it may seem, nor is it entirely advisable.

There are a couple of things you should know before undertaking such an investment.

First, that self‑directed IRA you mentioned is often called a “checkbook IRA” because under a specific process, you can get money from your IRA put into your checking account, and you can pretty much immediately access that cash for investment purposes.

You can invest in real estate of almost any kind you choose, with a few exceptions that I’ll outline later.

But for now, it’s worth noting that you can invest directly in a property, you can buy single‑family homes, a co‑op, a condo, or even land. You can buy a multi‑family place. You can even go into other real estate options like tax liens or deeds of trust or REITS, real estate investment trusts.

So it is possible to take your 401(k) or ROTH funds and to put them into a self‑directed IRA and make a variety of real estate investments.

The Importance of Diversification

I would caution you, however, against putting all of your Roth IRA and your 401(k) monies into a self‑directed IRA for real estate investments because, for starters, you wouldn’t be getting enough diversification.

Your retirement money is better-protected and more likely to grow when you have a mix of investments, as opposed to concentrating all your investments in just one investment class.

This is true of all investments: stocks, bonds, commodities and even real estate. You never want to put all of your eggs in one basket.

Also, you mentioned the recent uptick in real estate in certain cities across the country. Well, a couple of months of price improvement does not make a trend.

Think Long Term

Obviously, we’ve seen a period of nearly five years, from 2007 through the end of 2011 where real estate prices have generally been very soft and have been declining in many markets.

Any real estate purchases that you make, whether for your own primary residence or for investment purposes, really need to be carefully gauged and tightly scrutinized. After all, for most real estate deals, we’re talking about you spending six figures or more. And some of the cost of the purchase may have to be financed.

Speaking of financing, you must also know about certain traps that can occur when it comes to investing in real estate using your IRA. Most of these are tax traps.

Let me quickly explain a couple of them.

When you buy a property for your IRA, you have income and appreciation potential.

The income might be generated, for example, from tenants who pay you to live there. The price appreciation could occur if the value of the property you buy increases in value.

So this income and appreciation within your IRA normally builds up tax‑free and grows over time until you start to make withdrawals.

Now, the caveat there is that such monies are “typically” or “normally” tax free. But there can be cases where it might not be tax‑free. It really depends on how it is that you purchase the investment real estate in question.

Avoid Tax Traps

There are special tax rules that apply to debt‑financed income that’s contained within retirement plans.

In other words, if your real estate is mortgaged in any way, you have to file a form 990T with the IRS. Subsequently, not only does the income earned between the debt portion of and the non‑debt financing get allocated, but so too does the taxes on the property get allocated.

To illustrate this point, assume you bought a $200,000 single‑family home for your self‑directed IRA. And let’s say you put in $100,000 in cash to make that purchase, but the other $100,000 was financed or borrowed from a bank.

In very simple, basic terms, only half of that income generated from the real estate would be sheltered because only 50% of your purchase was made in cash.

The rest of the income that you generated from the property (the other 50% of income) would be subjected to ordinary income tax rates. That’s because you have debt there and 50% of the purchase was financed as opposed to non‑financed.

Thus, a lot of financial advisors say it’s a lot easier to do an all-cash transaction. Of course, not everybody has the money to just buy real estate outright, 100% in cash using their self‑directed IRA.

Not All Real Estate Qualifies

Another important point: there are certain kinds of properties that you can’t purchase when it comes to real estate investments with your self-directed IRA.

These restrictions have to do with the IRS trying to prevent you from having any kind of a personal benefit from your IRA investment before you reach a certain age.

That magic number, that age, is 59 ½. That’s the point at which the government says it’s no problem for you to start taking penalty‑free tax distributions from your IRA.

Because the feds don’t want you to benefit from your IRA investments before you hit age 59 ½ years of age, the IRS has certain rules stipulating that you can’t invest with “disqualified” parties and also that you can’t make certain kinds of investments in real estate.

For example, you can’t buy a home with your IRA that you would personally live in or that you would rent out to relatives.

That phrase “disqualified parties” includes you personally, any descendants of yours, or anybody in your family lineage, like your parents or grandparents, your spouse, your kids, grandkids, and so on.

It also even includes people who have a fiduciary responsibility to your account, like your certified financial planner, your advisor, or your accountant.

Really, the IRS is trying to do is to make real estate deals arm’s length transactions, and avoid what’s called self‑dealing.

Simply put, they want to make sure that you can’t do anything that might allow you to get any possible benefit from it from that IRA before you should (i.e. the age of 59 ½)

Therefore, you can’t transfer property that you already own into a retirement account. Neither can you buy a vacation house and then “rent it out” to yourself.

One other drawback to investing in real estate using a self‑directed IRA is that you’re going to lose your depreciation deduction. Inside a retirement account, it’s useless.

The flipside, of course, is that the cash flow you might get and any possible appreciation factor might outweigh the loss of your depreciation deduction.

So the bottom line is this: think carefully before you go ahead and invest in real estate with a self‑directed IRA, and make sure you’re aware of all the tax ramifications and the restrictions involved.

And certainly, whatever you do, please don’t put all of your 401(k) funds or all of your Roth IRA money into a self‑directed IRA for real estate. That just wouldn’t be wise.