Real estate investors are increasingly looking for ways to grow their portfolios and self-directed IRAs offer a way to invest in real estate while deferring or even eliminating taxes on earnings. Unlike traditional IRAs that focus on stocks and mutual funds, a self-directed IRA allows you to diversify into alternative assets like rental properties or raw land and even lending to other investors.
However, before using your retirement funds to invest in real estate, it’s important to understand that there are strict IRS rules regarding what an IRA cannot invest in. The IRS doesn’t provide a list of approved investments, but they do outline what is prohibited. Failing to follow these rules could trigger taxes, penalties, or even disqualify your IRA entirely.
Below, I outline five investments that are not allowed within an IRA:
1. Property for personal use
While real estate investments are allowed within an IRA, any property purchased with IRA funds cannot be used for personal purposes. This means you or another disqualified person cannot live in, vacation at, or otherwise use the property for yourself.
For example, if your IRA purchases a vacation rental property, you cannot stay there for even one night. The property must be strictly held as an investment and must not provide any personal benefit to you or any disqualified persons.
Additionally, any expenses related to the property (such as maintenance, repairs, and property taxes) must be paid directly from the IRA. Conversely, any income generated from the property (such as rental income) must be deposited back into the IRA and cannot be withdrawn for personal use until you reach retirement age.
2. Property you or another disqualified person owns
Real estate is a popular investment option for self-directed IRAs, but there are guidelines on how that real estate can be acquired and used. One of the biggest restrictions is that you cannot invest in property that you or another disqualified person owns or has previously owned.
A disqualified person includes you, the IRA owner, your spouse, direct ancestors or descendants like parents, grandparents, and children, and any entity where you or another disqualified person has significant ownership. For example, if you currently own a rental property and want to move it into your IRA, this would also be a prohibited transaction.
To avoid issues, IRA real estate investments must be entirely arms-length transactions, meaning you and any disqualified individuals cannot live in, work on, or personally benefit from the property in any way. The property must be solely for investment purposes.
3. A personally guaranteed loan or loan to yourself or another disqualified person
IRAs cannot be used to extend loans to you, your business, or any other disqualified person. Additionally, you cannot personally guarantee a loan that is taken out using IRA funds.
Here’s what that means in practice:
- You cannot take out a personal loan from your IRA, even if you intend to repay it
- Your IRA cannot lend money to your spouse, children, parents, or any other disqualified individual
If you use your IRA to purchase real estate with debt financing, the loan must be a non-recourse loan – meaning it is secured solely by the property and in the event of a default the lender’s only recourse is that collateral. If an IRA owner engages in a prohibited lending transaction, the IRS may consider the entire IRA distributed, resulting in taxes and potential penalties.
4. Collectibles
While IRAs can hold a diverse set of alternative investments, the IRS has specifically prohibited investments in collectibles. This includes items such as:
- Artwork and antiques
- Rugs
- Automobiles
- Stamps
- Precious gems and jewelry
- Alcohol
If an IRA is found to contain prohibited collectibles, this would be known as a prohibited transaction. According to IRS guidelines, the IRA then no longer exists, and the entire investment is treated as a distribution, potentially triggering tax liabilities and penalties.
5. Life Insurance Policies
Unlike other tax-advantaged accounts such as 401(k)s, which may allow certain life insurance investments under specific circumstances, IRAs cannot be used to purchase or hold life insurance policies.
IRAs are designed to be long-term retirement savings vehicles that provide future income, while life insurance policies serve a different financial purpose – providing a benefit to beneficiaries upon death. Because of this fundamental difference, the IRS prohibits life insurance contracts within an IRA.
Final thoughts
Self-directed IRAs can be a powerful tool for real estate investors, offering tax advantages and investment diversification. However, it’s crucial to understand what types of transactions and investments are prohibited to avoid unexpected tax liabilities. (You can find the entire list in IRS Publication 590.) Once you understand the few investments not allowed in an IRA, the many possibilities of what you can invest in become apparent.
If you’re interested in learning more about investing with a self-directed IRA, check out our 15-Minute Guide to Building Wealth through Self-Directed IRA Real Estate Investing. It breaks down how it’s possible fund more real estate investments and keep more of the profits with the step-by-step process of investing in real estate through a self-directed IRA.
Written by John Bowens, Director, Head of Education and Investor Success at Equity Trust Company
Equity Trust Company is a directed custodian and does not provide tax, legal or investment advice. Any information communicated by Equity Trust is for educational purposes only, and should not be construed as tax, legal or investment advice. Whenever making an investment decision, please consult with your tax attorney or financial professional.
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