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Real estate and self-directed IRAs

If you're tired of being limited to the typical lineup of stocks, mutual funds, bonds and CDs that most brokerages allow you to buy in your IRA, you might consider creating a self-directed IRA that enables you to invest in real estate.

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The addition of real estate can diversify a portfolio and, to be sure, buying actual property to be held in your IRA is just one way to do it. The process is not terribly complicated, but as with any retirement account, you must follow the letter of the law or face penalties from the IRS. Additionally, unlike the run-of-the-mill self-directed IRAs that allow you to invest in the aforementioned stocks and bonds, a self-directed account that holds real estate arguably requires considerably more work on your part. It is also a much higher-risk investment.

In his book, "The No-Nonsense Real Estate Investor's Kit," Thomas Lucier writes, "... the real estate investment business is full of four-letter words such as: hard, work, risk and loss."

If you don't know much about real estate, if you're not willing to do a lot of so-called "due diligence," and if you're not financially or emotionally prepared to handle significant risk, don't attempt this. Sure, you can make painful mistakes in the stock market, but, generally speaking, your investments are liquid and you can cut your losses quickly if you feel it's necessary. The real estate market is not as forgiving.

What an IRA custodian does
But if you're determined, start by opening a self-directed IRA or self-directed Roth IRA with a custodian or administrator. Although this article focuses on real estate, a self-directed IRA can hold trust deeds, secured and unsecured notes, limited partnerships, private stock and other nontraditional investments. An Internet search will probably turn up a couple dozen companies that will handle these types of investments.

However, don't expect them to advise you on what properties to buy. A custodian is a neutral third party and it is not allowed by law to give that type of advice.

"We act only as the IRA custodian," says Kelli Click, vice president at Sterling Trust Company in Waco, Texas. "This is a simple illustration of what takes place, but an individual comes to us, sets up an IRA and tells us they want to purchase the property at 100 Main Street. They find the title company, get everything in place, tell us to wire the funds to the title company and here's the closing date. We purchase the property and make sure it's in the name of the IRA account. We hold the property and provide the account holder with a quarterly statement, and we provide any IRS reporting for the IRA account."

Fees for custodian services vary, so be sure to get a complete list of fees before hiring someone.

You can use your self-directed IRA to buy your future retirement home, but you can't live in the home until you retire. You also cannot put a piece of property that you currently own into your IRA.

Next: "the biggest mistake ... is failure to understand the market."
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