Investing in Real Estate Lease Options in a Self-Directed IRA

Published on August 26, 2024

Real Estate Lease Options in Single-Family and Multifamily Properties are a Popular Alternative Asset

If you’re looking for a way to further diversify your self-directed IRA portfolio, and you are savvy about real estate investment properties, you may want to look at investing in real estate lease options.

Unlike a traditional lease, a lease option a) gives the investor more control over the property without officially owning it, b) provides a path to property ownership, and c) is a tax-advantaged investment when transacted through a self-directed IRA.

What is a lease option?

In general, a lease option (rent with the option to buy) enables a renter to purchase the rented property during or at the conclusion of a rental period. The owner may not offer the property for sale to anyone else during this time frame. When the rental period ends, the renter must buy (exercise the lease option) or forfeit the property. The tenant usually pays a rental premium that goes to the downpayment.

What is a lease option investment—and how does it work with a self-directed IRA?

A lease option investment is between a property owner and an investor—and is gaining popularity as a self-directed real estate investment.

The self-directed IRA (the investor) pays a monthly amount to the property owner, who retains responsibility for the mortgage. The terms are agreed upon in advance by both parties—in this case, the monthly amount and length of time (although other factors such as responsibility for repairs and maintenance or utility payments should be considered). The investor can extend the lease to a different tenant who pays the rent (which covers the monthly rental cost). As a self-directed investment, here’s how it works:

A. The account owner enters an agreement with the property owner that stipulates all relevant terms of the lease option.
B. The self-directed IRA makes monthly payments to the property owner.
C. The account owner finds a third-party tenant for the property.
D. The renter makes monthly payments to the IRA.
E. The retirement account sees positive cash flow when a renter pays more on the lease than the amount agreed-to by the investor and property owner.

NOTE: The tenant may not be a disqualified individual; this will create a prohibited transaction and puts the tax-advantaged status of the self-directed IRA in danger.

Optioning a property

When investors option a property, they make a relatively small upfront investment and decide later if they want to exercise the option and cash out the seller.

• The property is not acquired directly at the start. According to the contract signed between parties, the investor (self-directed IRA) may purchase the property at a set price within a specified time. For example, after the one-year lease period expires, the investor (IRA) may purchase the property for X dollars.
• In the meantime, the investor can lease the property and the self-directed IRA earns tax-advantaged cash flow during the option period.
• The investor may also choose to assign (sell) the option to another party for a profit. For example:
o Sam enters a lease option arrangement with a property owner and puts down a small “option consideration” from his IRA; this is a non-refundable upfront payment made to the landlord to secure the right to purchase the property during the lease term.
o The IRA rents the property from the owner for a certain monthly amount for a year.
o Sam finds a tenant who pays rent to the IRA (at more than what Sam pays the owner).
o At some point, the tenant negotiates with Sam (on behalf of his IRA) to sell/assign her the option. This gives the tenant the ability to purchase the property directly from the original owner, using the option Sam sold to her, and to do so at less than fair market value.
o Sam’s IRA earned positive cash flow every month from the rent and much more from the assignment of the option.

Building retirement wealth through lease option and subject to strategies

These real estate investment strategies can be combined to build more wealth. For example:

• The self-directed IRA purchases a subject to property and
simultaneously gets a lease option tenant. The deposit paid for the deal can be recouped from the lease option deposit—a wash at worst and a gain when the deposit paid by the tenant is more than what the IRA paid out.
• The IRA earns passive income when monthly rental payments coming into the account are higher than the monthly mortgage payments going out
• Selling the property to a tenant buyer at a higher price than the contracted purchase price at the start of the deal.

Another great investing option: a self-directed IRA at Next Generation

Comprehensive account administration, investor education, and excellent client service are three big reasons why self-directed investors have trusted Next Generation for 20 years. If you have a question about rental lease options or other real estate-related investments (or any other alternative asset these plans allow), contact us at 888.857.8058 or NewAccounts@NextGenerationTrust.com. You can also schedule a complimentary educational session for additional insights into self-direction as a retirement wealth-building strategy.