Using Self-Directed IRAs to Invest in Real Estate and Privately Held Businesses

Quite often, when it comes to saving for retirement, most people think about owning traditional investment options like stocks, bonds, mutual funds, and exchange traded funds (ETFs). Though those traditional investment vehicles certainly have considerable merit, other investors are increasingly seeking alternative options that provide greater control, potential for higher returns, and increased diversification, such as private real estate and privately held businesses.

While it is certainly possible to outright own said investments by writing a check and using “cash,” an arguably more favorable alternative emerging is a self-directed Individual Retirement Account (IRA). A self-directed IRA is a type of IRA that can hold various alternative investments typically prohibited from regular IRAs.

With self-directed IRAs, a third-party trustee is required to administer the account on behalf of the account holder. However, the account owner is authorized to give the trustee instructions regarding investments, funds, transactions, and account information, which is why they are referred to as self-directed.

Self-directed IRAs may be either traditional or Roth depending on whether you would prefer to make tax-deductible contributions today or receive tax-free distributions later on in retirement. Either way, a self-directed IRA stands apart from its conventional counterpart by granting investors the freedom to choose a wider array of assets for their retirement portfolio.

One significant advantage of investing in real estate and privately held businesses through a self-directed IRA is the potential for higher returns due to the absence of tax drag. Self-directed IRAs offer tax-deferred or tax-free growth, allowing investors to accumulate wealth without immediate tax implications. This can significantly enhance the overall returns on investments.

Investing in real estate and privately held businesses also provides a level of control unattainable with publicly traded stocks. When you invest in a property or a business, you can directly influence the success of your investment. You can improve a property to increase its value or work with the management of a small business to improve its profitability. With stocks, you're at the mercy of the broader market and the decisions of the company's management team.

Diversification is another important benefit of investing in alternative assets. By spreading your investments across a variety of asset classes, you can reduce risks and potentially increase returns. If the stock market takes a turn for the worst, for example, your real estate investments may hold firm or even appreciate over the same period. Similarly, tax diversification is a crucial benefit of using a self-directed IRA to invest in those alternatives. The tax code is ever-changing, and by having a variety of tax-advantaged investments, it helps create optionality when developing income streams in retirement.

While real estate and privately held businesses are the more prominent examples of alternative assets, self-directed IRAs can also be used to invest in a range of other non-traditional options. These may include precious metals, tax lien certificates, private loans, intellectual property, cryptocurrency, fine art, etc. This versatility allows investors to tailor their portfolios to specific interests, risk tolerance, and market outlook.

Real estate investment has long been considered a cornerstone of wealth building, and for good reason. The benefits of utilizing a self-directed IRA for real estate are significant and can offer investors a unique set of advantages. The most notable, however, is the lack of tax consideration when deciding whether to sell a property that has appreciated significantly. Where paying taxes on those gains or rolling them into another property of equal or lesser value is normally required, gains made on a property sold within a self-directed IRA remain deferred.

In many cases, privately held real estate has a long history of producing strong, consistent returns and can generate both income and appreciation. Privately held businesses, on the other hand, can offer significant growth potential if you invest in the right start-up. These types of investments can often be riskier than investing in real estate, but they can also provide higher returns.

One remarkable example that highlights the power of self-directed IRAs among privately held businesses is the case of the tech mogul, Peter Thiel. In 2021, it was revealed that Thiel's self-directed Roth IRA was reportedly valued at $5 billion due to some of its unique holdings—shares of startups in which he had made early-stage investments—such as Facebook and Palantir.

This lesser-known approach allowed Thiel to capitalize on the explosive growth potential of startups while benefiting from the tax-advantaged status of his IRA. The case of Peter Thiel underscores the versatility and flexibility that self-directed IRAs offer, enabling savvy investors to strategically channel funds into high-potential ventures. And while Thiel's case is certainly exceptional, it sheds light on the opportunities that self-directed IRAs can present for investors willing to play the long game.

While the potential benefits of self-directed IRAs are compelling, it is important to emphasize the need for careful consideration and professional guidance. Investors should approach self-directed IRAs with a strategic plan, thorough due diligence, and a clear understanding of the rules and regulations surrounding these accounts. Engaging with tax professionals and legal experts who specialize in self-directed IRA transactions can be instrumental in navigating potential pitfalls.

A self-directed IRA is a long-term investment tool, ideally suited for retirement and/or estate planning. Investors should be prepared to commit funds for the long haul, harnessing the power of compounding and patience to maximize the benefits of their self-directed investments. By aligning their self-directed IRA strategy with broader retirement goals, investors can build a robust and diversified financial foundation for generations to come.

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Malcolm Ethridge, CFP® is the Managing Partner of Capital Area Planning Group based in Washington, DC. He is also the Managing Partner of Capital Area Tax Consultants. 

Malcolm’s areas of expertise include retirement planning, investment portfolio development, tax planning, insurance, equity compensation and other executive benefits. 

 Disclosures:

The information provided is for educational and informational purposes only, does not constitute investment advice, and should not be relied upon as such. Be sure to consult with your legal advisors before taking any action that could have tax and legal consequences.

Investments in securities and insurance products are:

NOT FDIC-INSURED | NOT BANK-GUARANTEED | MAY LOSE VALUE