5 Devastating Retirement Traps For Real Estate Investors | Episode 195

 

ONE TOPIC is irresistible catnip for real estate investors:  the Self-Directed IRA.  This special form of IRA enables investors to deploy their retirement capital into real estate, and to enjoy the substantial tax benefits offered by IRAs.

IRAs can bring such substantial tax savings that it is easy to assume that any investment that can be performed in an IRA should be performed in an IRA.  But the devil is in the details, and real estate may be the only asset class for which the use of an IRA could be a fundamentally poor decision.

Here are 5 devastating traps awaiting the real estate investor who uses a Self-Directed IRA:

Punishing Taxes

It would be reasonable to assume that using an IRA would result in the payment of less taxes than without it.  Alas, that is frequently false.

Users of the “Roth” type of IRA have the best tax advantage ever created:  Your profits are 100% tax-free, and that advantage is impossible to beat.

But what about “Traditional” IRAs, which are merely tax-deferred rather than tax-free?  This is a highly relevant consideration, since there’s far more money stashed away in Traditional accounts versus Roth accounts.  Does the tax deferral of a traditional IRA outweigh the tax advantages of owning real estate outside of an IRA?

Generally speaking:  The traditional IRA is less tax efficient for real estate.

Real estate investments executed outside of an IRA are usually taxed at long-term capital gains rates, which are relatively low at 15-20 percent.  But if the same transaction happens in a traditional IRA, the investor will be hit with ordinary income tax rates during retirement, and those rates reach as high as 39.6 percent!

For the benefit of temporary tax deferral, Traditional IRAs force investors to sacrifice the relatively low tax rates of capital gains treatment and instead pay much, much higher ordinary income tax rates.

Cash Purchases Only… No Leveraged Purchases!

Using debt to purchase real estate is one uniquely wonderful reasons that savvy investors prefer real estate as an asset class.  But in some very tangible ways, debt inside of an IRA profoundly diminishes your tax benefits.

The law does not prohibit your IRA from borrowing money.  But doing so opens up your IRA to current tax liabilities, as the IRS categorizes income that results from debt in an IRA to be “business” income rather than “investment” income.

As a result of this “fine-print distinction,” your account could be hit with a particularly nasty tax called “Unrelated Business Income Tax”, which could chop another 39.6% off of your profits.

Non-IRA Tax Advantages Disappear

Real estate may be the most tax-favored asset class of all.  Even without the benefit of an IRA, real estate offers a plethora of tax-reducing potential that can have an immediate impact on the investor’s current income tax burden.

The two biggest examples are the “1031 exchange” and “depreciation.” The former enables investors to defer taxes on real estate profits indefinitely by reinvesting those funds into other real estate, while the latter enables some investors to substantially reduce their current income tax burden.

Unfortunately, those tax advantages are unavailable to you personally when it’s your IRA that’s doing the investing.  The IRS views your IRA as a distinct entity from you, and even if the activities of your IRA would merit tax advantages if performed outside of your IRA, the execution of your transaction inside your IRA means those advantages are not available to you.

Sweat Equity No More!

One of the greatest opportunities in real estate is the ability to substantially increase value through improving the property, such as making repairs, adding rooms or even constructing entirely new structures.  For real estate investors, it is all about “highest and best use.”

When the owner of a property performs this kind of work him or herself rather than paying a third party, it is called “sweat equity.” and it is an incredibly cost-efficient way for real estate investors to dramatically increase their equity at minimal cost.

However, the IRS sees it very differently, viewing your work on the property as a “service” that is provided to the IRA.  Unfortunately, the law expressly prohibits the IRA owner from providing services to the IRA, under threat of tax and penalties that are utterly devastating.

The Freedom To “Hang” Yourself

One would think that using a “Self-Directed IRA” would lead to profound freedom for the investor, yet the opposite is true.  While you are allowed to invest in nearly any asset class you like, the rules governing IRAs are very strict, inflexible and wholly unforgiving.

What does it take to break those rules?  It is easier than you might think.  Each of the following actions is arguably prohibited for your IRA-owned property:

Paying any bill connected with your IRAs property with personal (rather than IRA) fundsAllowing your boss, colleagues or family to use your IRAs beach-front propertyAllowing your granddaughter’s girl scout troop to sell cookies on property owned by your IRA

There is an untold number of ways to unintentionally commit a prohibited transaction, and the IRS has become rather aggressive of late in identifying these transgressions, as the payoff for them can be huge.  It is very plausible that committing any prohibited transaction could result in your IRA value being slashed by 50-100%, and there’s no simple way to fix these errors.

Despite these risk factors, real estate investors should not automatically avoid self-directed IRAs.  There are many excellent reasons for real estate investors to use self-directed IRAs as you’ll see in a future article.  Real estate investors should, however, avoid the common assumption that any investment that can be made in an IRA should be made in an IRA.  That is dangerously untrue, and the ramifications of making the wrong choice can be very negative for your financial security during retirement.

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