There is a lot of confusion when it comes to this topic. This week, I’ve summarized what I think the top 5 tips are to consider before your IRA invests in real estate.
While I’m focusing on the U.S. tax law here, the approach can be applied to retirement plans in other countries as well.
Tip #1: Understand the Special Tax Treatment Rules for IRAs
IRAs receive special tax treatment on certain types of income. The special tax treatment is that the income is not taxed currently. In the case of a traditional IRA, it is taxed when it is distributed – the tax is deferred. In the case of a Roth IRA, it is never taxed – the tax is eliminated.
The special tax treatment only applies to certain types of income.
The certain types of income include interest, dividends, capital gains and rents. If an IRA produces income that is not in this group of tax-favored income, then it could be taxable.
Tip #2: Identify the Type of Income Your Real Estate Will Generate
Real estate can generate interest income, rental income and / or capital gains. These are all tax-favored types of income in an IRA and, as such, they receive the special tax treatment.
Real estate can also produce ordinary income. An example of this is flipping real estate where real estate is bought with the intent to sell it quickly for a profit. Ordinary income is not in the group of tax-favored income and could be taxable in an IRA.
Tip #3: Determine If You Will Lose Tax Benefits
Rental real estate often generates losses for tax purposes even when there is positive cash flow. This is because of the depreciation deduction that can be taken on the investment.
When properly executed, rental losses can be used to offset other income which effectively shelters that other income from income tax. This can result in significant tax savings.
If an IRA has rental losses, the IRA is generally not paying tax so there is no tax to shelter. The tax benefits are potentially lost.
Tip #4: Measure the Impact of Leverage in Your IRA
Most of the wealth strategies I develop with clients include leverage. The most common form is a mortgage on a piece of property. Leverage can present a few challenges in an IRA.
First, there are tax consequences of using leverage in an IRA. To the extent an IRA produces income from assets that are leveraged, that income (even if it is tax favored income that is normally not taxed in an IRA) is subject to tax within your IRA.
There are some exceptions to this rule, but the strategy of regularly using the appreciation in a property to fund new deals can present tax consequences to an IRA.
Second, finding a lender who will finance real estate in an IRA may be difficult because you cannot personally guarantee a loan made to your IRA without jeopardizing the tax benefits of your IRA (this is explained more in #5). Therefore, the mortgage must be non-recourse financing secured only by the IRA’s assets.
Tip #5: Assess Your Role with Your IRA
With more and more people using self directed IRAs, I see more and more people getting in trouble with the prohibited transaction rules.
Your role with your IRA can have serious tax consequences. If an IRA engages in a “prohibited transaction”, it can lose its favorable tax status and the entire value of the IRA can be taxable to the owner as a distribution and may include penalties.
A prohibited transaction is a specific transaction the IRS has disallowed if it takes place between your IRA and a “disqualified person.”
A disqualified person includes, but is not limited to, you, your spouse, your parents, your grandparents, your children, a person providing services to the IRA and entities that are controlled 50% or more by you or any others included in this list.
Prohibited transactions include, but are not limited to, the sale, lease or exchange of property, lending money or extending credit to or from your IRA and providing services to your IRA.
Understanding the Rules
As I mentioned, there is a lot of confusion in this area. As you understand the rules, the confusion will fade and the right strategy for you and your IRA will become clear.
While I’ve been focusing on real estate here, the same approach can and should be used with other types of investments. I think the best approach is to look at it as part of your overall wealth strategy to determine which investments should be done inside your IRA and which should be done outside of your IRA.
Focus on your wealth!
By: Tom Wheelwright – Tom’s firm provides my tax advice and wealth planning. I encourage you to check out ProVisionWealth.com