Rentals in SD-IRA?

When I read my Sunday morning newspaper today, I saw an article by a personal financial columnist who said that the average investor should not invest in a Self Directed Individual Retirement Account because it is necessary to have expensive legal and tax advice before doing so.

Probably the most common use of a SD-IRA is to invest in rental real estate.  In my opinion the best arena to invest in is in an area where you have knowledge and are comfortable.  There are areas in the country such as Fort Collins, Colorado where residential real estate has been an excellent investment for more than 50 years.  If you understand the laws and best practices regarding renting a residential property, and live in an area, like Fort Collins, which has a great history for residential real estate and by most accounts a great future for residential real estate, I cannot think of a better investment.   You can touch it, see it, and understand most everything about it.

Compare that to investing in a mutual fund owning hundreds or thousands of stocks.  You will never understand or even see much of any of the companies that you invest in.  Even if you did, most of us are not sophisticated enough understand corporate books if we were allowed to review any record kept by any of those companies.

So, if you accept my idea that for many, investing in local residential real estate may be an ideal investment, what about the SD-IRA part?  That is a very legitimate concern.  The giants in the IRA industry such as Fidelity and Vanguard do not want to have anything to do with the SD investors.  That, of course, is due largely to that fact that they have a huge chunk of the highly lucrative and mostly low risk market of individual investors in the stock and bond markets.  The SD (self directed) is obviously more risky in that, instead of Fidelity or Vanguard making and controlling investments in the stock and bond markets for their investors, the SD custodians handle the paperwork for transactions made and largely controlled by the investors themselves.  In these SD transactions the purpose of both of the custodians and the investors is to try to convince the IRS that all of its rules are being complied with.  Fidelity and Vanguard likewise must assure compliance with IRS rules and regulations, but they control everything...all the investor does is send them the money.  In the SD world the custodians only control the paper trail...they can only hope that the investor is complying with all of the IRS rules and regulations.  The custodian's risk is that when there is an IRS audit that finds noncompliance, the investor will blame the custodian and the custodian will blame the investor.  Fidelity and Vanguard do not need that headache.

Thus, the SD investor in local residential real estate must accept the additional risks of working with the smaller and less sophisticated custodians and the risk of being on their own  in complying with the IRS rules and regulations.   As usual this decision rests on risk analysis----is the benefit of having an ideal investment worth the risk being found out of compliance by the IRS?  Certainly that is only a decision that can be made on an individual basis.  Weigh the risks and happy investing.

Posted on July 13, 2014 .