What To Avoid When Buying Real Estate in Self-Directed IRA's
Self-directed individual retirement accounts are very attractive to the real estate investors. These special IRAs allow the investors to put their retirement capital into real estate and enjoy the substantial tax benefits offered by IRAs. However, in some cases, using a self-directed IRA for real estate investments can hurt investment results.
Let us look at four ‘traps’ that you must look out for if you are investing in real estate with self-directed IRA.
Payment of Fewer Taxes
It may seem like IRAs eliminate taxes on investment profits, however, that is not the case. Roth IRA holders have the best tax advantage as their profits are 100% tax-free. On the other hand, traditional IRA isn't tax-efficient for real estate.
Real estate investments executed outside an IRA are usually taxed at long-term capital gains rates at around 15% to 20%. However, if the same transaction happens in a traditional IRA, the investor's profits will be hit with ordinary income tax rates during retirement, and those rates would be as high as 39.6%.
For the benefit of temporary tax deferral, traditional IRAs force investors to let go of the relatively low tax rates of capital gains treatment and instead pay much higher ordinary income tax rates.
Only Cash Purchases
One of the main reasons why investors prefer real estate as an asset class is because they can use debt to purchase real estate. But in some tangible ways, debt inside an IRA profoundly diminishes the tax benefits.
The law doesn't prohibit an IRA from borrowing money, but if you do this, a lot of tax liabilities will come forth as the Internal Revenue Service categorizes income that results from debt in an IRA as business income, rather than investment income.
Due to this fine print distinction, an account could be hit with a tax called unrelated business income tax, which could chop another 39.6% off of profits, which would be due on the present-day tax liability.
Non-IRA Advantages Disappear
Real estate can be one of the most tax-favored asset class. Buying real estate offers numerous tax-reducing potential which can have an immediate impact on the investor’s tax burden.
Two such examples include 1031 exchange and real estate depreciation. The former allows investors to defer taxes on real estate profits indefinitely by reinvesting those funds into another real estate, while the latter allows some investors to substantially reduce their income tax burden.
However, those tax advantages are unavailable to an investor when it is his or her IRA doing the investing. The IRS views an IRA as a distinct entity from the holder, and even if the activities of an IRA would merit tax advantages if performed outside an IRA, the execution of the transaction inside an IRA means that those advantages aren't available to the investor.
No Sweat Equity
A great opportunity in real estate is the ability to substantially increase the value through improving the property — like adding more rooms, making repairs or constructing new structures altogether.
When the owner of the property carries out all these tasks on his own instead of paying a third party, it is called sweat equity, which is an incredibly cost-efficient way for real estate investors to increase their equity at minimal cost.
However, the IRS views an investor's work on the property as a service that is provided to the IRA. The law clearly prohibits the IRA owner from providing services to the IRA, under threat of tax and penalties that are utterly devastating.
Using self-directed IRA may have several risk factors but the real investors should not avoid self-directed IRAs. Investing in real estate with self directed IRA has numerous benefits, which you must definitely consider.
About the Author:
Rick Pendykoski is the owner of Self Directed Retirement Plans LLC, a retirement planning firm based in Goodyear, AZ. He has over three decades of experience working with investments and retirement planning, and over the last 10 years has turned his focus to self-directed accounts and alternative investments. Rick regularly posts helpful tips and articles on his blog at SD Retirement as well as Business.com, SAP, MoneyForLunch, Biggerpocket, SocialMediaToday and NuWireInvestor. If you need help and guidance with traditional or alternative investments, email him at firstname.lastname@example.org.