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Self-directed IRA Real Estate Investment Problems

Picture of self-directed IRA real estate investment investor rolling rock up hillIn some popular online forums, participants regularly tout the idea of self-directed IRA real estate investment or self-directed 401(k) real estate investment.

After writing dozens of messages rebutting this gambit, I finally realized I’d save time by summarizing here the ten big problems an investor creates with this approach to funding investments in real estate.

So I’m going to do that… finally.

Problem #1: No Sweat Equity Bump

Direct real estate investment often works well (and maybe only works well?) because the investor bumps his or her return with sweat equity.

A landlord who can, for example, do repairs or improvements himself or herself bumps the value of the property.

A real estate agent or broker who saves or earns a commission on the purchase or sale of a property gets an extra way to profit.

You can’t, however, do this sort of stuff with a self-directed IRA or 401(k). These entanglements violate one or more rules and may, in a worst-case scenario, cause your IRA to lose its tax deferred status and thereby trigger taxes on the entire balance as well as early withdrawal penalties.

This is a big loss for small real estate investors. A giant loss, in fact.

Problem #2: No Family Income Splitting

A related way direct real estate investment may create value for investors is that it allows family income splitting.

Family income splitting, in a nutshell, moves income from heavily taxed members of a family to lightly taxed members of a family.

This tactic often saves money for successful, established real estate investors. But you can’t use it with real estate that’s located inside an IRA or 401(k).

Maybe this is a bit premature to mention if you’re just starting to think about real estate as an investment category, but you want to think about the long run…

Problem #3: Loss of Passive Loss Deductions

A self-directed IRA real estate investment as well as self-directed 401(k) real estate investment won’t generate passive losses that let the real estate investor shelter other highly taxed income.

This is a big deal for some investors. Some real estate investors reap big rewards, for example, by using depreciation deductions to shelter highly taxed dollars of ordinary income.

Investors with household incomes of less than $100,000, for example, can use up to $25,000 of passive, paper losses from real estate to shelter other income. And some wealthier investors can use the “real estate professional” designation to use any amount of passive losses to shelter other income.

Unfortunately, you lose this opportunity if you’re investing inside your IRA. Or inside your 401(k).

Note: A common tax planning gambit for married couples is to have one high-income, highly-taxed spouse work at a great job and then have the other spouse run the family’s real estate investment portfolio but in a way that generates tax deductions which shelter the other spouse’s earned income.

Problem #4: Use of Sec. 1231 Losses to Shelter Ordinary Income

If you lose money in a direct real estate investment, you can use that loss (technically a Sec. 1231 loss) to immediately shelter any other sort of income.

Further, if you lose so much money that you drive your income to zero for the current year, you can use the remaining loss (now called a net operating loss) to go back and reduce the previous two years of income to zero and then maybe do the same thing in future years.

Note: If you’re interested in how real estate losses create deductions you can use to shelter any type of income, read about Donald Trump’s Net Operating Losses.

But here’s the thing you need to understand if you’re thinking about the idea of self-directed IRA real estate investment. You can’t use losses within your IRA to shelter income earned outside your IRA such as your wages earned during your highest earning years.

Note: In effect, with a self-directed IRA real estate investment or 401(k), you’ll “use” or experience these losses at some point far into the future when you take less money out of your IRA or 401(k).

This tax accounting quirk count as another lost benefit of self-directed IRA real estate investment and self-directed 401(k) real estate investment.

Problem #5: Conversion of Unrecaptured Sec. 1250 Gains to Ordinary Income

Though you have to pay back any depreciation deductions you take on real estate if you later actually make a profit, for direct real estate investors that tax rate will very possibly be lower than your ordinary tax rate. Why? The depreciation you have to later pay back gets taxed at the lower of your ordinary tax rate or 25%. This approach saves money for taxpayers taxed at a rate above 25% obviously.

Admittedly, this tax accounting treatment doesn’t necessarily save you money. But it can.

And then this important point: You lose this minor tax rate benefit you invest via a self-directed IRA or 401(k).

Problem #6: Conversion of Sec. 1231 Gains to Ordinary Income

Self-directed IRA real estate investment also torpedoes capital gains treatment of the profit you make when you sell real estate. And this is a biggy.

The profit you make on a direct real estate investment, assuming you’ve held the property for longer than a year, gets taxed as long-term capital gains. That means that profits from direct real estate investments will always be taxed at a way lower rate (probably 0% or 15% and worst case at 20%) than the profits you earn inside an IRA or 401(k) and which will at some point be paid out to the investor as ordinary income (rates as high as 39.6%)

Problem #7: Loss of Sec. 1014 Step-up in Basis

An awkward benefit to mention but an important one to know about if you’re planning for success..,

If you own a property when you die (or if you’re married, live in a community property state, own a property and either you or your spouse die), you don’t and your heirs don’t pay taxes on the profit or the depreciation payback.

This benefit flows from Sec. 1014 of the Internal Revenue Code and is called a step-up in basis.  (I mention the actual chunk of tax law here in case you want to do a bit of research). But this is a big benefit you lose.

Note: Money your heirs end up drawing out of your IRA will be taxable to them.

Problem #8: Loss of Opportunity to Gift Interests

While on the subject of estate planning, let me mention that you will be able to easily gift interests in direct real estate investment to your heirs if that becomes a part of an estate plan due to your great success in real estate. You cannot, however, gift interests in your IRA or 401(k) to an heir.

Note: You can name beneficiaries for an IRA or 401(k) to make sure the money goes to the beneficiary. But that’s not the same thing as while you’re still alive gifting assets to heirs. Gifting can save state or federal income taxes, doesn’t trigger taxes for the beneficiary and also shouldn’t trigger taxes to the giver.

Problem #9: Preparation of 990-T Tax return

If your IRA or 401(k) invests in real estate and uses borrowed money, your IRA or 401(k) will need to file its own tax return and pay income taxes on the income it earns. No, really. It will. I’m not making this up.

Obviously, this requirement to file a 990-T becomes a meaningful expense and significant hassle. Sorry. (More information here.)

Problem #10: Higher Fees for Self-directed IRAs and 401(k)s

A final quick point: Your self-directed IRA will burden you with extra fees—costs over and above what you would pay if you invested directly—and these further diminish the attractiveness of this approach to real estate investing. For large dollar IRAs and 401(k)s, you may pay a couple of grand a year. And if you need to invest through an LLC, remember that state fees can run several hundred dollars a year in some of the less-than-business-friendly states like California.

Other Related Blog Posts You Might Find Interesting

Real Estate vs. IRA and 401(k) Accounts, Part I

Real Estate vs IRA and 401(k) Accounts, Part II

Smart Wealth Strategies of the Top One Percent



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About Carol St. Amand

Carol St. Amand

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