IRA Real Estate: Alternative Investing Through Tax Deferred Accounts

Do you have a 401(k), IRA, or even HSA account(s) currently earning less than spectacular returns? Did you know that you can use IRA real estate, Solo 401k or other self directed accounts to invest in alternative investment vehicles such as real estate?

In today’s bull(ish) market, you really should be reviewing your portfolios for asset allocation and the corresponding exposure to risk. Does the stock market feel a bit over-heated to you? It may continue to increase for the next couple of years, but corporations have boosted the value of their shares through easy money financing so the real question is: when will the easy money stop and will you be prepared for it?

A great way to diversify your holdings and hedge against a correction is to purchase IRA real estate with your deferred tax investment vehicles. There are several ways to add IRA real estate to your portfolio:

1. REITs
2. Private lending
3. Syndications and/or crowdsourcing
4. Tax liens
5. Notes
6. Buying your own rental property

You can invest in each of the above with tax deferred accounts. Note: there are special rules regarding each investment vehicle and it is highly recommended you speak with qualified professionals to plot a course of action prior to engaging in any of the above investments.

Benefits of IRA Real Estate Investing

The benefits of investing in IRA real estate may seem somewhat obvious, but let’s cover them anyway. Allocating monies to real estate solves that asset allocation problem and protects you from a market correction at the same time. Additionally, depending on how you are investing in IRA real estate you may find that you enjoy the increased control over your funds.

Control grants you the power of making management decisions – the ability to make management decisions can help your investment grow substantially. To illustrate, if you own a rental property and you know the roof is due for a repair within the next five years, you may want to sell that rental property today. If you don’t have control over your investment, you can’t make that call – ouch!

Investing in Rental Property Through an IRA

Let’s take a look at how an IRA may go about investing in rental real estate. An IRA is its own financial and legal entity separate from your personal finances. The IRA can secure a loan to take title to the property and can take legal title to a rental property, or even set up an LLC and have the LLC take title to the property. The IRA will become the decision maker and will be responsible for hiring the property managers and contractors, and managing the day-to-day cash flow.

There are obvious benefits here – this can be so streamlined and so passive that you can be sipping your Jamaican Breeze on the beach at St. Johns USVI and simply watching your retirement account(s) grow. The tax benefits are also huge (contrary to popular belief as explained in a minute) as your funds always grow tax free!

Any good finance article should discuss the downsides and risks. First, income generated by the IRA real estate property must go back into the IRA. Rent checks must be made out to the IRA and the monies cannot pass through your personal bank account. Additionally, you may not personally pay for any of the expenses related to the rental property. The IRA needs to function as a separate “business” and as such, must pay for its own expenses and liabilities, including the ones relating to the IRA real estate investment.

The second con is that disqualified persons cannot provide services to or work on the property. Remodeling, repairs, improvements, and maintenance must be performed by a non-disqualified person or entity. Disqualified persons include: YOU, your parents, your grandparents, your spouse, your children and their children and their children and so on. Additionally, your IRA cannot purchase a property from or sell to you or any disqualified person.

Lastly, if your IRA purchases real estate utilizing a non-recourse loan, the debt financed portion of the property’s profits may be subject to Unrelated Business Income Tax (UBIT). Speak with an advisor prior to going down this route.

But Real Estate is All About the Tax Benefits… Right?

True, investment real estate provides phenomenal tax advantages. I’ve seen people legally avoid paying a cent in taxes for years due to their investment real estate. With real estate, you control how much income you report through repairs, improvements, and varying depreciation schedules. Expenses on one rental property can even offset the income from another, separate rental property.

So why advocate to invest in IRA real estate using a tax-deferred investment vehicle? Well, aside from the advantages already mentioned above, there is one more key benefit: you don’t have to pay a cent in tax on the assets you sell.

If you have ever hung out around a real estate investor crowd, you may have discussed ways to avoid capital gain taxes and depreciation recapture. If those are foreign concepts to you, don’t fret as they are easy to understand. When you sell a capital asset, you have to pay capital gain taxes on the appreciated portion of the asset. Additionally, if the asset has been depreciated, you have to pay a percentage of that depreciation back (the IRS allows you to shelter income via depreciation while you own an asset as they want to encourage investing, but when you get out, boy I hope you have a good exit plan!).

To avoid these taxes, investors often discuss tax deferred strategies, such as 1031 exchanges. The problem with a 1031 exchange is that your depreciable basis “erodes” over time. This is because when you engage in a 1031 exchange, you must roll your proceeds into a building that is of the same or higher price, however, you keep the adjusted basis of the original property. Foreign language? Let’s look at an example:

Assume you are considering selling a property that you purchased two years ago. You purchased it for $100,000 and the improvement value was $90,000. Two years of depreciation amounts to $6,545 ($90,000/27.5 x 2) leaving you with an adjusted basis of $93,455 ($100,000-$6,545). You are going to sell the property for $150,000 meaning you will have to pay capital gains tax of $7,500 ($50,000 x .15) and depreciation recapture tax of $1,636 ($6,545 x .25). To avoid these taxes, you engage in a 1031 exchange and roll the $150,000 proceeds into a property that cost $500,000 BUT you maintain your old adjusted basis of $93,455 in the new property.

If you take a multi-year outlook, multiple 1031 exchanges will cause you to purchase properties that produce more and more cash flow but less and less annual depreciation, and subsequently more and more taxable income. For instance, you can be in a position where you have a $4,000,000 building, producing $600,000 in net operating income, and recording annual depreciation of a mere $500. This is the downside to 1031 exchanges that no one talks about, and poor planning here can cause a tax nightmare.

If you are investing in IRA real estate, none of the above matters. You simply sell your property, avoid the capital gain and depreciation recapture tax hit, and purchase a new property when you choose to. Sure, you don’t get the benefit of shelter annual cash flow, but you don’t need it. Over a span of 10, even 20 years, IRA real estate investors tend to find themselves in par with, and even slightly ahead of their non-IRA investor counterparts.

Summary

Investing in real estate is a great way to diversify your assets and hedge the risk of a market correction. You can invest passively, and the benefits can greatly outweigh the negatives. As with any sort of investment and tax planning, it’s a good idea to include a range of professionals to advice on the tax, financial, and legal aspects of any given plan.

I hope you find this article useful. If you have any questions, please feel free to ask.