One of the most common arguments against the use of a Self-Directed IRA to purchase real estate is that IRA distributions are subject to ordinary income tax, whereas a sale of real estate would be generally subject to capital gains tax. This article will explain the tax benefits of tax deferral for real estate investors and compare them to the tax treatment of using non-retirement funds to purchase real estate. In the end, it’s up to you, the investor, to decide if a Self-Directed IRA for real estate is better than the capital gains tax treatment.
- Choosing whether to own real estate in an IRA or personally comes down to the individual investor
- Real estate owned in a Self-Directed IRA is not subject to tax until a distribution is taken
- Income generated from a personally-owned property is subject to tax, however, there are some advantages to doing so
What is Tax Deferral?
The primary advantage of using a Self-Directed IRA to purchase real estate (or any other investment for that matter) is the power of tax deferral. The U.S. retirement system is based on the power of tax deferral. Tax deferral is when all gains generated by a pretax retirement account investment flow back into the retirement account without tax. This allows your retirement funds to grow at a much faster pace than if the funds were held personally, allowing you to build for your retirement more quickly. This is also known as compounding interest, which Albert Einstein has coined the 8th wonder of the world.
The concept of tax deferral can be best understood by way of an example. Let’s assume George invested $210,000 in 2016 to buy a home with his Self-Directed IRA. He rented the home out to a third-party, and each year received $60,000 in rental income. After expenses and taxes, George’s IRA earned a net $25,000 of tax-deferred income. In other words, the $25,000 went back to the IRA each year without tax. In 2021, George sold the house for $490,000, which went back to his IRA without tax. This is one of the major benefits of using an IRA to buy real estate.
Taxation of IRA Distributions
In order to fully analyze the use of a Self-Directed IRA to buy real estate, it is important to examine the tax treatment of taking IRA distributions. An IRA distribution is when IRA funds are withdrawn from the IRA and transferred to the IRA owner for personal use. In other words, the funds are no longer in a tax-exempt retirement account.
All traditional IRA distributions are treated as earned income and are subject to tax. If you are under the age of 59 1/2, you may be subject to an additional 10% early withdrawal penalties. Once you reach that age, only taxes would be due on the distribution.
To determine the amount of tax due, the amount of the IRA distribution would be added to the IRA owner’s other income reported on IRS Form 1040. Additionally, once you reach age 72, you are subject to required minimum distributions. You must start drawing down your IRA with an approximate 3% withdrawal of IRA funds. This amount is also subject to ordinary income tax.
Taxation of Roth IRA Distributions
Unlike a pretax or traditional IRA, a Roth IRA is funded with after-tax money. Therefore, there is no immediate tax break. The major benefit of the Roth is that all qualified distributions are tax free during retirement. To be qualified, you must be at least age 59 1/2, and have a Roth opened for at least five years. If these conditions are not met, any distribution of earnings is subject to tax and possible early withdrawal penalty. Bear in mind that contributions made to a Roth can be distributed at anytime without tax or penalty.
The one drawback of the Roth is the income restrictions. If you earn too much money, you cannot directly contribute to a Roth-type plan. For 2022, if you earn more than $144,000 (filing as a single) or $214,000 (married filing jointly) you cannot fund a Roth directly. However, you can utilize the Backdoor Roth strategy to get funds into the plan.
Lastly, unlike the traditional IRA, there are no required minimum distributions. You never have to withdraw from the plan if you don’t need to. Instead, you can pass it, in full, to your beneficiaries.
Clearly, using a Self-Directed Roth IRA is the ultimate real estate tax strategy.
Buying Real Estate with Personal Funds
When one uses non-retirement, personal funds to purchase real estate, income from the real estate investment would be subject to ordinary income tax. However, gains from the sale of the real estate would be subject to capital gains.
Short-term capital gains is taxed at ordinary income tax rates of the investor and is triggered if the asset is held for less than 12 months. If the asset is held for longer than 12 months, the investor would benefit from a reduced capital gains tax rate of 15% (or 20% for income above $501,000). Note – for high income earners, the 20% capital gains tax rate is also subject to a 3.8% net investment tax.
Benefits of Using Personal Funds to Buy Real Estate
One of the major tax advantages of buying real estate is the concept of depreciation. Real estate depreciation is essentially an income tax deduction that allows a taxpayer to recover the cost of the real estate investment. In general, one can only take depreciation deductions up until the cost or basis in their property has been deducted.
The three elements needed to calculate the amount of depreciation is the investor’s basis in the property, the recovery period (the time period for which the depreciation is being claimed), and the depreciation method used. Since 1986, depreciation period for residential property is 27.5 years and 39 years for a commercial asset.
In other words, the benefit of depreciation provides the real estate investor with an annual deduction that can offset any income from the real estate asset. For example, rental property investors can include depreciation as one of the expenses on Schedule E when they file their yearly taxes.
In addition, Accelerated Depreciation is an accounting method that allows the owner of an asset to depreciate the asset more rapidly by using a shorter period of depreciation than the traditional straight-line method. For example, certain land improvements can be depreciated over 15 years at a 150% declining balance, with certain personal property depreciated over 7 or 5 years at a 200% declining balance.
One item to note which many real estate investors seem to ignore, upon a sale of a real estate asset, if depreciation has been taken than the investor must pay a higher tax on the depreciation recapture account. The depreciation recapture rate on this portion of the gain is 25%, which is still less than the highest ordinary income tax rate, but higher than the long-term capital gains tax rate.
Leverage & Real Estate Investments
The IRS imposes certain restrictions for Self-Directed IRA investors seeking to use a loan (leverage) to buy real estate. Firstly, the loan must be nonrecourse. That is, the loan cannot be personally guaranteed by the IRA owner. Second, a percentage of the income associated with the nonrecourse loan could be subject to an additional tax known as the Unrelated Business Taxable Income tax (UBTI or UBIT), which has a maximum tax rate of 37% for 2022.
Keep in mind, if you are self-employed and utilize the Solo 401(k) plan, there as an exception for UBTI. Arguably, for this reason alone, the Solo K is the best plan for real estate investors if you qualify.
On the flip side, when a real estate investor using personal funds uses a loan to buy real estate, the investor gains more purchasing power to increase returns.
For example, Valerie has $200,000 to invest into a real estate project. She purchases a $1 million property using 80% loan-to-value ratio, whereby she puts the $200,000 down and finances the rest at a 3.5% interest rate on a 30-year mortgage. Let’s assume that property produces annual net operating income of $65,000, she will be responsible for loan payments of $43,000 per year ($800,000 loan amount, 3.5% interest rate, 30-year mortgage), leaving Amy with a total cash flow of $22,000 ($65,000 in net operating income minus loan payments of $43,000). This results in a cash-on-cash return of 11% ($22,000 in cash flow divided by $200,000 of invested capital).
If Valerie invested the full $1 million in cash without a loan to purchase the property “unleveraged,” the cash-on-cash return would have only been 6.5% ($65,000 in net operating income divided by $1 million in invested capital). Hence, it is clear why every real estate investor seeks to use leverage when purchasing real estate.
Use a Self-Directed IRA or Personal Funds?
There is not really a correct answer whether one should use a Self-Directed IRA or personal funds to buy real estate. Just like tennis and pickle ball: both great games that involve a ball and racket, but are still different sports with different rules. Most investors want to use IRA funds to buy real estate because they have available funds in their IRA and they wish to diversify their retirement assets away from equities. Below is a list of some of the advantages and disadvantages of using Self-Directed IRA vs. personal funds to buy real estate:
Self-Directed IRA Advantages to Buy Real Estate
- Take advantage of tax deferral or tax-free investing, in the case of a Roth
- Invest in hard assets as a hedge against inflation
Self-Directed IRA Disadvantages to Buy Real Estate
- Ordinary income tax and not capital gains tax-treatment when taking a distribution (exception for a qualified Roth IRA distribution)
- UBTI tax when using leverage (exemption for a Solo 401(k) plan)
Use of Personal Funds Advantages to Buy Real Estate
- Capital gains treatment on sale if held longer than 12 months
- Depreciation deductions
- Ability to use 1031 exchange to defer gains
Use of Personal Funds Disadvantages to Buy Real Estate
- Real estate asset held less than 12 months will be subject to ordinary income tax
- Limitation of depreciation deductions
- Depreciation recapture
Overall, whether an investor uses a Self-Directed IRA or personal funds to buy real estate, the ability to gain exposure to the real estate asset class has proven to be a wise investment over the years. As outlined above, each case has its advantages and disadvantages. Although, the ability to use a Self-Directed Roth IRA and, especially, the Roth Solo 401(k) plan seems to be the most tax advantageous.
For IRA investors, the ability to diversify ones retirement portfolio, as well as generate tax-deferred (or tax-free) gains are the main advantages. Whereas, in the case of an investor using personal funds, the ability to generate capital gains tax treatment and accelerated depreciation deductions are very attractive tax benefits.
The good news is that the IRS allows one to use personal or retirement funds to buy real estate, so we can all take advantage of the opportunity to invest; it’s up to you to decide the best way to own it.