Real estate is expected to be a popular investment category in 2023. With the threat of inflation increasing and with uncertainty in the equity and crypto markets, retirement account investors seeking a hedge against inflation and investment diversification are expected to focus on real estate.
- 2022 was a tough year across the board, but real estate should come on top this year
- Investing in a tax-advantaged retirement account, such as a Self-Directed IRA, can help properly diversify your portfolio
- Beware of the UBTI tax when using leverage to make an IRA real estate deal
What is a Self-Directed IRA?
There is no specific definition of what a Self-Directed IRA is. It simply refers to an IRA account which is permitted to be invested in traditional assets, such as stocks, but also alternative assets, including real estate. In the last several years, the number of Self-Directed IRA accounts has grown significantly.
If you want to properly diversify your retirement assets, you need to self-direct your retirement account, whether it be an IRA or a Solo 401(k) if you are self-employed. Traditional financial institutions may offer the ability to self-direct, however, you’re generally limited in your investment options. At IRA Financial, there’s no limit in what you can invest in – invest in what you want, when you want, so long as it is not prohibited by the IRS.
Why use a Self-Directed IRA to Buy Real Estate?
There are several reasons why million of retirement account investors have made real estate investments. The following are the most popular reasons for making real estate part of one’s retirement portfolio:
Tax-Deferred or Tax-Free Cash Flow
Using an IRA or other retirement plan to invest in real estate can provide the retirement account holder with tax-deferred (with a traditional IRA) or tax-free (using a Roth IRA) income or gains. In general, all income from the sale of real estate or from rental income would flow back to the IRA without tax. Owning income-producing real estate in an IRA can provide tax-advantaged cash flow, plus the opportunity to generate long term, tax-free gains on the sale of the real estate.
2022 was the highest rate of inflation our economy has experienced in nearly forty years. As a result, many retirement account investors may be looking for ways to protect their portfolios from the ravages of inflation. In general, having the ability to invest in certain hard assets, such as real estate, is seen as a good way to protect your retirement account. After all, you have the ability to increase rent or sell for a higher price as necessary.
Whether it is through retirement investments, such as IRAs or 401(k) plans, or personal savings, most investors have a high percentage of their savings connected in some way to the equity markets. Investing in non-equity assets offers a form of investment diversification from those markets. In general, the more diversified your portfolio, the greater chance that your assets will offer lower correlation, meaning they are less likely to move in the same direction. Self-directing allows you to adjust your holdings on the fly, all while protected from taxes.
Invest in Something You Understand
Many Americans became frustrated with the volatility of the equity markets. Real estate, for comparison, is easier to understand. Real estate is quickly becoming a mainstream asset category and one of the most trusted asset classes for Americans. Many investors feel comfortable with the ability to use their retirement funds to invest in an investment they can understand, which provides one with the ability to stay in his or her comfort zone. Real estate is much less complicated investment than the stock markets or cryptos.
Choose the Plan that’s Right for You
There are several types of self-directed retirement plans that you should consider. There is no one right answer when asked, “which is the best plan for me?” It’s up to you to decide which plans fits your overall financial goals better.
The Self-Directed IRA
With a Self-Directed IRA, a special IRA custodian, such as IRA Financial, will serve as the custodian of the IRA. All types of IRAs can be used in a self-directed structure, including Roth (see below), SEPs and SIMPLEs. Unlike a typical financial institution, which generates fees by selling products and providing investment services, a Self-Directed IRA custodian earns fees by simply opening and maintaining IRA accounts and do not offer any financial investment products or platforms.
Hence, with Self-Directed IRA, the funds are generally held with the custodian. The IRA owner (you) will then direct the custodian to invest the IRA funds in IRS-approved alternative asset investments, such as real estate. Title to the asset will be in the name of the custodian, care of the IRA owner. A “regular” Self-Directed IRA, which is custodian controlled, is a popular with retirement investors looking to invest in alternative assets which do not involve a high frequency of transactions, such as the purchase of raw land or private fund investments.
The Self-Directed IRA LLC
A Self-Directed IRA LLC is quite different than a custodian controlled IRA, but should be set up with a special IRA custodian as mentioned above. Once created, the IRA is then invested into a special purpose limited liability company (LLC), which your custodian can help you establish. The use of the LLC provides the IRA owner with greater protection as well as greater privacy.
The Self-Directed IRA LLC is then managed by the IRA owner providing him or her with “checkbook control” over the IRA funds. With checkbook control, the manager of the Self-Directed IRA LLC, will have the authority to make the investment decisions without the involvement of the custodian. All of the investments will be titled in the name of the LLC, offering the IRA owner more privacy. You can now invest in a real estate deal without ever having to ask permission from the custodian.
All types of IRAs can be transferred, tax-free, to a Self-Directed IRA LLC. The structure is popular with IRA investors seeking to invest in assets, such as rental properties, fix and flips, tax liens, or cryptocurrencies that require a high frequency of transactions.
Not sure which plan to use? Schedule a consultation to learn your options!
The Self-Directed Roth IRA
Unlike a traditional IRA, a Roth is funded with after-tax money, meaning there is no immediate tax break on contributions. The biggest benefit of the plan are tax-free distributions during retirement. However, you must bide your time or suffer penalties. In order for a distribution to be qualified (and not subject to tax or penalties), any Roth IRA must be open for at least five years, and the participant must have attained age 59 1/2. That’s it! From there on out, any withdrawal from the Roth with be tax free.
One can use a Roth as part of the Self-Directed IRA solution. So long as you are under the annual income thresholds set forth by the IRS, you can contribute to a Roth. If you earn too much money, you are still allowed to convert other retirement funds to Roth, you just need to pay the tax on the conversion. One other advantage of investing with a Roth is there are no require distributions once you reach age 73. Your investments can continue to grow unhindered for however long you want.
The Self-Directed Roth IRA is popular among real estate investors who do not need the immediate tax break a traditional IRA offers. Generally, the more time you have until you retire, the more advantageous a Roth is. Imagine selling a Roth-owned property for $1 million, and all that income comes to you with paying a cent in tax?!
The Solo 401k) Plan
Lastly, let’s briefly mention the Solo 401(k) plan and why it’s beneficial to real estate investors. Only self-employed individuals or small business owners with no full-time employees can establish a “Solo K.” So, if you don’t qualify, you can skip to the conclusion. However, if you are considering going out on your own, and looking to invest in real estate, you should read on.
Just like an IRA, one can self-direct his or her Solo 401(k) plan. Again, you need to set up the plan with the right company, or else you may end up with an inferior plan. The plan allows for much higher annual contributions than an IRA, the ability to take a long, and, most importantly, an exemption to a certain tax on real estate purchases.
Beware of Taxes
That tax is known as Unrelated Business Taxable Income, or UBTI. Another four-letter acronym, UDFI, or Unrelated Debt-Financed Income, does not apply to Solo 401(k) plans. When using leverage (borrowing money) to make a real estate investment in an IRA, you will be subject to the 37% UBTI tax. The earnings generated are taxed based on the percentage of IRA funds vs. borrowed funds to make the investment. A straightforward example is using $50,000 of IRA funds and leveraging $50,000; that’s a 50/50 deal, which means half of the earnings would be subject to the tax.
Pursuant to Internal Revenue Code Section 514(c)(9), a 401(k) qualified plan is not subject to the UDFI rules and, thus, the UBTI tax if nonrecourse leverage is used to acquire property, such as real estate.
When using a high percentage of leverage, the Solo 401(k) plan is the clear winner, but obviously, not everyone can utilize the plan. It’s important to keep in mind the application of the UBTI tax when using a Self-Directed IRA. The more cash you can use on the investment, and the lower the borrowed funds are, the more tax-efficient the investment will be.
Diversifying your retirement holdings is imperative, especially during times of economic uncertainty, and high inflation. There’s a reason why real estate is the most popular alternative investment around: it is easy to understand a generally, provides a hedge against inflation and other economic difficulties.
It’s up to you, the investor, to decide which IRA is right for you. Do you want to be hands-on, or take a more hands-off approach? Do you want an immediate tax break, or can you wait until the future to reap the tax benefits? There’s no one right answer.
Lastly, if you are self-employed, don’t forget the enormous benefits of the Solo 401(k) plan; if you’re not, you must pay close attention to the UBTI tax so that a tax-advantaged investment doesn’t turn into a nightmare.