Why CRE Brokers Should Avoid Using a Self-Directed IRA for Real Estate Investments

1. Strict IRS Rules and Compliance Risks

The IRS enforces strict rules under IRC Section 4975 to prevent self-dealing and prohibited transactions. Violating these rules can lead to the disqualification of your entire IRA, triggering immediate taxation and penalties.

Prohibited transactions include:

• Personal Use: You (or disqualified persons like your spouse, children, parents, etc.) cannot use or benefit from the property.
• Self-Dealing: Renting the property to a family member or managing it yourself is prohibited.
• Providing Services: You cannot perform repairs, act as the real estate agent, or manage the property.
• Financing Violations: Personal loans or guarantees for IRA-owned property are not allowed.

Accidentally violating these rules can result in the IRS disqualifying the entire IRA, making the full balance taxable with penalties

2. Unrelated Business Income Tax (UBIT) and Unrelated Debt-Financed Income (UDFI)

If an SDIRA purchases real estate using leverage (a non-recourse loan), income generated from the property may be subject to Unrelated Business Income Tax (UBIT) at trust tax rates, which can reach 37%.

• Unlike traditional real estate investors, SDIRA holders cannot use depreciation or deductions to offset UBIT.
• This significantly reduces the tax benefits typically associated with real estate investing

3. No Personal Contributions for Expenses

All property-related expenses—maintenance, taxes, insurance—must be paid from the SDIRA itself.

• If the SDIRA lacks cash, you cannot inject personal funds, creating a liquidity trap.
• This restriction can force you to sell assets at an inopportune time or face penalties for prohibited transactions.

4. Risk of Losing Tax-Advantaged Status

A single prohibited transaction—even an accidental one—could disqualify your entire SDIRA.

• This results in immediate taxation on the full account balance plus penalties.

5. Loss of Traditional Tax Benefits

Normal real estate investors benefit from tax-saving strategies such as:

• Depreciation deductions
• Mortgage interest deductions
• Capital gains tax treatment on sales
• 1031 exchanges (deferring capital gains tax)

With an SDIRA, these tax advantages do not apply since everything is tax-deferred or tax-free (Roth IRA). Additionally:

• Capital gains inside an SDIRA are taxed as ordinary income when withdrawn.
• 1031 exchanges cannot be executed within an SDIRA.

6. No Long-Term Capital Gains Treatment

Typically, real estate sales qualify for long-term capital gains tax rates (0%, 15%, or 20%, plus NIIT for high earners).

• However, SDIRA withdrawals are taxed as ordinary income, potentially at a much higher rate

7. Required Minimum Distributions (RMDs) and Higher Future Taxes

With a traditional SDIRA, you must start taking Required Minimum Distributions (RMDs) at age 73. This can be particularly challenging for real estate investments, as generating the necessary liquidity to cover the RMDs may require selling properties.

• RMDs force taxable withdrawals, potentially pushing you into a higher tax bracket.
• Future tax rate increases could make this issue worse.

8. Complex Estate Planning Issues

Passing real estate in an SDIRA to heirs adds complications:

• IRS requires fair market valuations.
• Beneficiaries face strict distribution rules and tax implications.
• Managing or liquidating the asset can be challenging.

9. No Step-Up in Basis for Heirs

When real estate is inherited outside of an IRA, heirs receive a step-up in basis, eliminating capital gains tax on appreciation.

• In an SDIRA, no step-up in basis exists.
• Instead, heirs must pay ordinary income tax on withdrawals, likely at their highest tax rate.

10. Custodian Fees and Administrative Burdens

SDIRAs require a custodian to hold assets and process transactions, adding costs and complexity.

Common fees include:

• Annual account fees ($200–$500 per year)
• Transaction fees (for purchases, sales, payments)
• Asset valuation fees (for IRS reporting)
• Distribution fees (when withdrawing funds in retirement)