Part 1- Question on rental income from a property in a self-directed IRA. Lets say that I own a SFH within a IRA. I sell the house, and the profit from the sale go back into the IRA. So that profit should be tax exempt. Now I buy a rental property, say an apartment building, and keep it in the IRA, using that profit money. How is the positive cash flow handled from the Apartment within the IRA? Does that income have to stay in the IRA, or can I collect that outside the IRA and simply pay income tax on the income?
Part 2- For this fictional apartment in the IRA, can I claim depreciation on it to reduce the taxable rental income? Or do I have to defer the depreciation until I sell.
If the cash flow stays inside the IRA, then the income earned by the IRA is tax free until you take a taxable withdrawal. If you take the income from the rental for yourself, it will be considered a distribution from the IRA taxed at your ordinary income tax rate plus whatever early distribution penalty applies (10%)
Part 2- For this fictional apartment in the IRA, can I claim depreciation on it to reduce the taxable rental income? Or do I have to defer the depreciation until I sell.
Since the rental income is earned by the IRA, there is no taxable rental income. You still take a depreciation expense and adjust the cost basis accordingly. I am not clear on this point, but I believe depreciation is still recaptured when the IRA sells the property.
What you lose with this IRA strategy is capital gains tax treatment on the sale of the property when owned by the IRA. Instead, your profit is taxed at your ordinary income tax rate when you withdraw it. You also lose the net passive loss allowance rental property owners are permitted against other ordinary income.
I am not an expert. That said, as I see it, you forfeit too many tax benefits to hold your rental property in an IRA. If I have anything wrong, I am sure one of the CPAs in this forum will step in with the correct answer.
A minor but important upfront correction: The profit you make on the SFH will be partially taxable if you use leverage. That’s the thing people who promote this idea don’t tell you.
Specifically, your IRA (like any other nonprofit entity) will owe unrelated business income tax (UBIT) on the profit that comes from its use of leverage (i.e., borrowed money). You will also need to file a tax return for the IRA, a 990-T.
My general advice to clients it to NOT use a self-directed IRA to invest in real estate. You add a bunch of costs to your investing. And you convert favorably taxed real estate income (unrecaptured Section 1250 gain and long-term capital gains) into ordinary income taxed at your highest marginal rate.
Also, you need to ultimately think about the required minimum distribution rules…
I understand your point regarding holding income property inside the IRA. However, I must disagree on the general advice. Despite the hassle, there is no better way to take advantage of the tremendous gains possible in real estate while boosting retirement income.
We (my wife and I) personally are invested in six limited partnerships within self-directed IRAs returning an average of 28%(annually) on timeframes ranging from 18 to 60 months.
You just can’t get that kind of return from your Fidelity mutual funds.
Are you doing the 990-Ts, though? I see a lot of people that skip this step… :argue
I also wonder how the loss of stuff like loss of unrecaptured Sec. 1250 gain and loss of capital gains and forced annuitization at age 70 1/2 affect the returns.
I’m not saying the idea of investing retirement money in real estate is bad… (or even good, for that matter).
I’m just questioning the tax affect of using an IRA.
I base this reservation on analysis I did for a client, a real estate professional, who looked at the long-term finances of (OPTION 1) investing in real estate through another self-directed IRA and paying ordinary income taxes on the back end…and (OPTION 2) pulling money out of IRA, paying taxes and penalties at that time, but then paying preferential tax rates from then on.
In this case, you really saw no significant benefit in using self-directed IRA… only extra costs (like for the 990-Ts, etc)… and some long-term financial puzzles (like how to make the required minimum distributions)
Having the IRA own anything directly puts the custodian in charge. You need to send them a form to do anything with the investement and most charge a fee each time. You have to wait for them to fund the deal. Some custodians charge an annual fee based on the value of the IRA assets.
I prefer Mark’s strategy. Create an entity and direct the custodian to invest IRA assets in it. You can make yourself a manager and then have complete control of the assets and never have to ask the custodian for anything. You do what you when you want subject to prohibited transactions, self-dealing, prohibitted, and UBIT. Some people take it a set further and direct the entity to invest in a c-corp that is owned less than 50% by the IRA owners. That relieves the need to comply with the restrictions mentioned above. This is a complicated strategy and should only be set up by a qualified person.
That way it’s all tax free at the end.