I’m posting this on both blogs, the one on Real Estate Investing, and the one on Property Management. If you signed up to follow both blogs, that’s why you are receiving two notices for the same comment. I think both groups would be interested in this topic.
Warning: This is a really complicated subject, and advice could change depending on your particular circumstances and plans. That’s why this article is very general. I just want to give you the idea, so you can investigate further, if you are interested.
Traditional IRAs usually invest in stocks, bonds, and similar investments. If you are true believer in real estate, though, you should think about setting up a self-directed IRA for some or all of your real estate investments. All income must stay in the IRA, and cannot be distributed until retirement age. Otherwise, you will have to pay large penalties and taxes, just the same as if you took money out of a regular IRA.
IRA income (whether from rents or selling properties) is not taxed until you make distributions when you retire. If you have other sources of income to meet your regular living expenses, putting real estate or a new business into a self-directed IRA is a great way to save on your taxes. For example, PayPal CEO Peter Thiel did just that when he earned more than $30 million tax-free after eBay bought his company.
How the post-retirement distributions are taxed depends on whether you set up a regular self-directed IRA, or a self-directed Roth-IRA. With a regular one, you exclude your contributions from your income taxes for that year. If you earn $50,000, but put $2,000 into your IRA, then it’s the same as earning only $48,000. That’s called investing with “before tax dollars.” In that case, distributions from the IRA will all be taxed at ordinary income rates, even if some of the profits came from selling real estate and would otherwise qualify for capital gains treatments. If you set up a Roth-IRA, then you put after-tax dollars into the IRA. That means you pay taxes on the whole $50,000 in my prior example, and THEN transfer money into the IRA. Because you paid taxes “on the front end” with a Roth-IRA, later distributions will be allocated among basis, capital gains, or ordinary income. In other words, no taxes on some part, capital gains taxes on some parts, and ordinary income rates on some parts of the distributions.
As great as self-directed IRAs might seem, the IRS feels rather passionately about their rules. “My football, my rules,” is their attitude. You can’t blame them. If you don’t follow the rules exactly, you’ll lose your tax benefits and get hit with penalties and interest. The biggest and most important rule is the one that forbids self-dealing. You can’t sell your own property to the IRA. You can’t buy property from your IRA, and you can’t live in property owned by the IRA. You can’t manage the IRA yourself, but will have to hire a 3rd party to do that. The fees are not large. You also can’t be too involved in the property or business owned by the IRA, but will have to hire a property manager or business manager. That could be a deal breaker for you. Further, if the property is financed, you cannot guarantee the loan. Most banks require 30% to 50% down before they will finance real estate without a personal guarantee.
To get around most of the self-dealing issues, many people set up an LLC to own the real estate, and then have the self-directed IRA invest in the LLC. The LLC then borrows the money and you guarantee the debt. The LLC (meaning, you) manages the property. It’s a silly game, but one with great rewards if you play it correctly.
For more information, talk to your tax professional, or one of the companies that manage Self-Directed IRAs for people. Here is a link to a list of custodians.
Be aware there have been lawsuits against some custodians for not checking out investments before placing account holders into them. If you want to have a self-directed IRA so you can invest in real estate in your community, that shouldn’t be a problem for you. You will be relying on your own advice, not that of a custodian. Your custodian will just keep track of bookkeeping for you, filing reports with the IRS, and keeping you informed about IRS laws that might affect your portfolio.