There are so many exciting tax efficient strategies that one can take advantage of with a Self-Directed IRA. Even more so when you utilize the Roth IRA, where all qualified distributions are tax free. This is especially true when it comes to real estate investors. You can enjoy the tax-free income it generates and eventually live it in it tax-free if it was purchased using a Self-Directed IRA. The following will discuss how you can do that and all the benefits of the plan.
- When you self-direct your IRA, you can invest in alternative assets, such as real estate
- Qualified Roth IRA distributions are always tax free
- IRS rules prohibit one from benefiting from an IRA investment, but only while it’s held inside the plan
The Self-Directed Roth IRA
When the Roth IRA was created, investors have been using it to shelter IRA income and gains from taxation. The primary advantage of using a Self-Directed Roth IRA to make investments is that all income and gains associated with the Roth IRA investment grow tax-free and will not be subject to tax upon withdrawal or distribution. Unlike a traditional plan, you don’t receive an immediate tax break; you need to be patient to reap the tax benefits of the plan. However, it presents a number of exciting tax strategies.
Funding a Roth IRA
There are generally three ways to fund a Roth IRA: contributions, transfers and rollovers. Contributions are the most straightforward way funding a Roth. You may contribute after-tax funds to the plan up to the annual limit (which is $6,500 for 2023). You may contribute an additional $1,000 in 2023 if you are least age 50. Be wary of the income restrictions. If your annual income is too much, you cannot directly contribute to a Roth IRA. However, you can utilize the “Backdoor Roth” strategy to get funds into the plan.
Rollover and Transfers are essentially the same thing. Transfers occur from like accounts (such as Roth IRA to Roth IRA), while rollovers come from different accounts (401(k) to IRA). Direct transfers and rollovers can be performed at any time and are not taxable events. Indirect transfers or rollovers (where you, the IRA owner, takes possession of the funds first) can be done once every 12 months. If you do take possession of the funds, you must re-contribute them to a retirement plan within 60 days or it will be treated as a distribution.
One last thing to touch on about funding a Roth IRA is the conversion. A conversion is a taxable event when you wish to move traditional (pretax) retirement funds to a Roth. You can convert as much as you want, whenever you want, you just need to be aware of the tax hit.
Buying a House with a Roth IRA
If one wishes to invest in real estate with IRA funds, he or she will need to set up a Self-Directed IRA. Traditional firms generally only offer traditional assets, likes stocks, mutual funds and the like. Once you set up your Self-Directed Roth IRA, you can invest in just about anything you wish. Real estate has long been the number one alternative asset among investors. Once you set up your plan, and fund it via one of the methods mentioned above, you’re on your way to being a property owner/investor. Locate the house you wish to purchase, and work through the process.
Once you are the proud owner of the new house, you can take advantage of the benefits of holding it in a Roth IRA. Read on to learn more!
Benefits of Holding Real Estate in a Roth
For tax attorneys, the Roth IRA rules provide an opportunity for some exciting tax planning opportunities. This is especially true for real estate investors. For example, one could use Roth funds to buy a rental property. Rental income would flow back to the plan; no taxes would be due because it’s held in a tax-advantaged retirement plan. When it comes time to take a distribution, you will owe no tax on the amount withdrawn assuming two things. First, you are at least age 59 1/2 and second, the Roth has been open for at least five years. That’s it!
When the time arrives when you wish to distribute from the plan, you have even more options. Let’s assume the property is the only asset held in the plan. It was purchased for $200,000 and now is worth $600,000. You can sell the house (while still inside the Roth) and distribute cash from the plan (tax-free assuming you satisfy the conditions above). You can withdraw any or all of it, whenever you want.
How to Live in the Roth-Owned Home
The alternative, and the point of this article, is to take an “in-kind” distribution from the Roth IRA. Instead of selling the house, after you reach age 59 1/2, you can move it from inside the IRA to your personal possession. Again, this would be a tax-free event.
IRS rules prohibit you from personally benefiting from an IRA-held asset. Once the asset is no longer inside the plan, you can do whatever you wish with it. That’s how you can buy a home with a Roth IRA and live in it, all tax free! Obviously, if you plan to take this route, make sure you go with a house that will stand the test of time and is exactly the place you wish to retire in. The whole idea is to use the property as an income generator, with the eventual plan to take it over.
Real World Examples of the Strategy
Example 1: Ken is 55 years old and uses $295,000 of Roth IRA funds to buy a home in Florida. He rents the house to a non-family member and earns $20,000 of profits annually. At age 62, the property is worth $400,000 and Ken takes the home as an in-kind distribution. Since Ken is over the age of 59 1/2 and the Roth has been opened at least five years, the distribution is 100% tax free. The title of the property is changed from the Roth IRA to Ken personally.
Example 2: Amy is 51 years old and is looking for a tax-efficient investment that will hedge against inflation. She decides to buy a rental property for $325,000 with her Roth IRA. The home is located in a desirable neighborhood and is close to where her primary residence is located. She rents out the home to her brother, since a sibling is not treated as a “disqualified person.” The rental income flows back to the Roth without tax. At age 60, Amy decides she wants to let her daughter move into the home. Thus, Amy takes a tax-free in-kind distribution of the property. Title of the home is changed from the Roth IRA to Amy personally; Amy can then gift the home to her daughter or simply allow Amy to live there.
Example 3: Maria is 47 years old and her dream is to retire in Spain where she was born. Maria decides to buy a home in Spain with her Roth IRA and allow her cousin to live in it Once she turns 59 1/2, she can take an in-kind distribution and then use it for vacation or to live in permanently. This strategy allowed Maria to buy the home at a good price, generate tax-free income, and then have the option to move into the home tax free.
Roth IRA Tips
Below are several key tips real estate investors should keep in mind when trying to maximize roth IRA tax strategies:
- Have patience. You must wait until you satisfy the distribution requirements to receive the full tax benefits of the plan.
- Trust the process. Try your best to not take premature distributions. Do your best to preserve the tax-free nature of the Roth.
- Due your diligence before investing. Smart real estate investors make money on the purchase and not the sale.
- Add to your Roth IRA. Continue to fund the Roth each year you have available money.
- Investment flexibility. There is a myriad of real estate-related opportunities out there. Plus, you can withdraw plan funds or assets.
- Beware of the IRS Rules. Prohibited transactions, and UBTI (when using leverage) must be kept in mind when transacting with real estate in an IRA.
There are so many exciting Roth IRA tax strategies available to all investors. One of the more popular ones is doing exactly what Maria did in Example 3 above. Buy a home with Roth funds at a younger age; generate rental income; and then taking personal possession of the home tax free.
There are many other smart tax strategies that real estate investors have employed to take advantage of its distinct tax-free investment advantage. The primary keys is to be patient and trust the process, but even if your investment goals change, the beauty of the Roth IRA is that all income and gains from the investment will be tax free.