Rentals or Flips - Retirement Real Estate is Solid
Real Estate. It’s what most people looking for ‘self-directed IRA’ (or 401k plans) are interested in. Residential, commercial, long-term or short-term holds; the principal goal is the same:
Earn profit from property with no income or capital gains tax due. Ever (if possible).
First: The process of buying property with your retirement account has gotten much easier in the last decade. The horror-stories and hassles are no-more with just a little planning.
Second: The differences in taxation and treatment of IRAs and Solo 401ks in real estate is huge, so as an investor, understand how their differences would impact you.
So let’s walk through how this works (good, bad, and ugly). By the end you’ll know a much more than most investors (and advisors) about how retirement accounts (properly) buy, finance, manage, and sell property. You’ll have a pile of citations, and solid ‘What now?’ options.
This write-up is the culmination of countless hours of research, direct conversations with the DOL and IRS, and real life experience creating and working with these accounts. We’ve watched competitors charge for seminars covering this information (to be fair, we hear they had snacks). ...and we’re posting it for you. Not even an email required.
All we ask in return is that you take action. Make a choice to work with us, work with someone else, or decide to love the stock market. But make a choice and take action.
If you (or one of your advisors) want to go over something at a technical level or walk through a specific situation, we’ll get you the answers you need .
There are two main ways to profit from real estate: Rental income or capital gains
Each approach has its own merits; by adding the proper retirement account structure, you gain flexibility and new advantages with either method – but there are drawbacks to consider.
What’s the main disadvantage of a flipping a property? Short term capital gains tax. If you can turn a property in a matter of months and earn five years’ worth of rental income, why not do it? Well, if between state and federal taxes you’re going to lose 40%+ of your profit - it takes a lot of the appeal away… why not wait at least a year? That could lower the tax bill by more than half. But now we’re talking about leaving it vacant or finding a renter… neither option is pleasant for most flippers.
The solution is to buy it in your retirement account. Flipping properties in your 401k/IRA will generate zero short term capital gains tax. None. A disadvantage? How much you earn tax-free, and how hard you work to do it, matters. Nebulous guidelines? Yes. The IRS used to grant three deals a year to retirement accounts tax-free; now they say ‘it depends’ (and we have reports of 8+ a year being tax-free in some cases and as few as one in others). Still – You get transactions where you keep every penny of profit.
What was the tax bill on your last flip? Next time keep it all.
(As an aside, if you want to do more transactions tax-free, it may be possible with a degree of extra planning and expense. Our experts can assist if you would like a higher level of activity. If you flip property, you need to explore this option. Period. There’s no better tool for flipping than a Solo 401k.)
Invest in rental properties? Buying a rental means you’ll benefit from any appreciation while collecting rent each month along the way… and that’s pretty appealing.
One of the greatest areas in US tax code is real property deductions. Whatever income a property generates; you can likely deduct a healthy portion of it. And one day, if you sell, you can 1031 the property to avoid capital gains tax.
Owning property in the US for rental income is a fairly tax efficient thing to do… So why buy property with your retirement account? When would you buy a rental property in your retirement account? When you’re concerned about future tax rates being higher than current ones. When your capital is in a retirement account and you want to invest in real estate.
Let’s say you buy a property now with the goal of collecting a rent check from it, or other properties, until the day you die. For roughly 20 years (and climbing) after retirement age, you’ll be collecting rental checks. For most people, even with deductions and expenses, it’d be fair to assume an effective tax rate of at least 20%.
Let’s say you’re able to collect $5,000 a month in rental income from properties in retirement. In your Roth IRA or 401k, that’s an extra $1,000 a month you keep instead of paying it in taxes each month. No more risk. No changes at all… you just keep each and every dollar. Even if your account was a ‘taxable’ traditional account, you still benefit from the protective tax-free, multi-decade, compounding of rents and sales.
Come distribution time, there are methods available to reduce the total tax bill to something more manageable. If your plan is a long term one, the math favors a retirement account owning the property… be that a Traditional or a Roth.
Maybe our (historically low) tax rates will fall even more, or maybe your income in retirement might be sharply lower (not what I’d want to bank on). If so, the real estate retirement account approach might not payoff. There are cases on both sides of the ‘rental in a retirement account’ decision; but it’s a much better choice than most people realize. Taking time to evaluate the option with us and your advisors will serve you well.
What if your retirement funds are Traditional right now? Conversion efficiency is complex enough to be a topic for its own report. It is a very situational matter that considers your total funds, timeline, and professional support. Our experts can talk to you and your advisors about if, when, or how, to best convert retirement funds from Traditional to Roth for maximum benefit. Just email or call and see how much can be saved in taxes by doing things in a planned way.
Are there advantages to buying rental properties outside your retirement account? Financing is definitely easier and faster as a direct buyer. You can work on it yourself.
You can have a high degree of leverage if you own the property personally – often investment properties up at 80% LTV (loan-to-value). In a retirement account, you’ll be hard pressed to get an LTV over 70% and the APR is usually higher (from 0-3% higher). That can be fine when flipping; it can make a big difference with long term rentals.
Some investors want to do the work themselves on their rental properties. If you have the time and skills, that’s a real advantage; but if your retirement account (of any kind) owns the property you’re not legally allowed to do the work. You can handle the administration (paying the bills, interviewing prospective tenants, etc); but doing things like wiring a new socket or fixing a toilet is out of bounds (generally speaking, physical labor is not allowed).
If you don’t plan to swing any hammers personally, and you like buying either with cash or a large down payment, then neither of these advantages matter. Go with the biggest tax advantage to maximize your gain for your hold pattern.
What’s the story on the taxes, loan issues, and penalties that come up? There’s all manner of confusion being spread… Let’s clarify a couple points and terms so you better understand the unique challenges found with these structures before you start.
Retirement accounts can’t use regular loans. They’re only allowed to use ‘non-recourse’ loans. This is because your retirement account can legally only accept cash from you; all other contributions are prohibited. …So if to get a loan the retirement account used your credit or other assets to guarantee it, the law would breached, and in the case of an IRA, the entire account would be distributed, taxed, and likely penalized too. Not good.
If you’ve ever tried to sell short in your retirement account, you may have been told ‘it’s not allowed’ by your brokerage. The reason is restriction above. It’s fine for your account to do those things… but the brokerage’s ability to get repaid if things fell apart would be virtually nil. You must be very careful since neither brokerages nor banks are familiar with these rules in general… and it’s your account, not theirs, at stake.
Banks who make commercial loans are often comfortable with non-recourse loans; but to buy just a home or a small apartment complex can take effort if you’re using a local lender. There are banks and other lenders that do them regularly. While we help you get them done for better rates with local lending options, we’ve also included several national non-recourse options clients have had good experiences with in our resource links at the end of this write-up.
An advantage of a non-recourse loan is that your personal credit or loan count isn’t a factor. The loan is evaluated on the merit of the property (or properties) in question. The importance of this can hardly be overstated for those with all the mortgages allowed from traditional lenders or people with a bankruptcy.
This type of loan can be your golden ticket back into real estate.
Retirement accounts can still be subject to taxes. The full matter is complex enough to fill a book. That said; we can concisely provide the key concepts for real estate investors.
UBIT (“Unrelated Business Income Tax”) is a section of taxation related to active business income that impacts both 401k and IRA funds.
A brief (relevant) history lesson: UBIT was created in 1950 to tax non-profit organizations running businesses. It’s difficult to compete against someone who doesn’t pay taxes. UBIT said that a non-profit could operate a business; but if they did they’d pay on that income at the highest tax rate.
It also takes all the fun out of buying a Subway franchise in your IRA (or 401k) since it would pay more income tax each year than you would if you owned it yourself, and you’ll still owe taxes on any traditional distributions come retirement. Not good. Not good at all.
UBIT had a subsection, UDFI (“Unrelated Debt Financed Income” also just called DFI) added in 1969. In a nutshell, UDFI makes leveraged profits taxable (like say, real estate with a mortgage against it). 401k plans have a key exemption.
UBIT and UDFI apply to all retirement accounts, but UDFI doesn’t apply to 401ks when the debt financed income is from real estate. This causes a lot of confusion and bad information. …but it’s fantastic news for both ‘buy-and-hold’ and flippers alike.
UDFI can crush IRA returns: If you have rental properties earning $100,000 annually (after all deductions to make the math easier), and the loan-to-value is 50%, then you’ll give up roughly $20,000 in taxes each year if you own it in an IRA - even in a Roth IRA.
The tax only applies to highest amount of debt in the past 12 months. So if you can pay off the property and hold it for a year before selling, your capital gain will be tax free even if your IRA used financing to acquire it. You also get all the regular real estate depreciation and other advantages to reduce the tax bill. That said; it’s a real burden and deterrent to any short term IRA buy/sell activity using debt.
But remember: UDFI doesn’t apply to real estate in 401k plans. So for real estate investors; switching from an IRA to a Solo 401k isn’t just a good idea - it’s a great one. Due to safety and features covered in our 401k-or-IRA, article it’s an outstanding option even before considering the elimination of the punitive UDFI tax. ...if you’re in real estate, you absolutely should get more information about what a Solo 401k can do for you. It’s more money in your account with no added risk.
Taking it all in – Your retirement account can be safer, and grow faster, than most ever believed possible. The secret is structuring it to give you the control you need while keeping the tax benefits intact. With real estate you gain some significant advantages:
- The ability to invest the money in assets you can physically see, touch, and select.
- The ability to leverage the money if you desire.
- The ability to time when you sell… without having to pay for (or find) a 1031 exchange.
- The ability to flip properties and pay nothing in taxes.
- The ability to collect rents tax-free during retirement with a Roth 401k or IRA.
We’ve developed a ‘Give 20, Get 20’ Self Directed Retirement Question and Feasibility Consultation to help answer that. To make sure we’re helping the right people it works like this: You’ll get 20 minutes of our time for giving $20 to a range of great charities. These are the same experts who you’d be speaking with if you hire us for any of our services. You get your questions answered, we only talk to people who are serious about getting things handled, and charities get all the money (we even cover the credit card processing). It’s a triple win.
Here’s what we’ll accomplish together in this session:
- Your current questions answered. One or two unknowns can confuse and clutter a situation, making it more complicated that it needs to be. Let’s quickly and easily clear up any lingering questions and provide a sound picture for you. Once we’ve walked through all your questions, you’ll immediately have a better idea what works and what doesn’t to meet your goals (and understand the quality of the support we provide).
- Cost Savings without Hassle. You’re all too familiar with how easily taxes and financial service fees can eat away your earnings. We’ll review four key areas related to retirement accounts that most people and advisers miss that can add thousands to your retirement income. Anyone who reviews your situation from our firm has reviewed hundreds of high net worth individuals’ situations and retirement accounts with investments both domestic and abroad. We will give you options in a clear and complete fashion.
When you call please provide a morning and afternoon call option. We usually fit in your consultation within 48 hours. Upon request, the call can be recorded and a copy sent to you so you don’t have to worry about taking notes – you can just concentrate on the discussion.
Secure a time by phone, 888-509-1551, or email [email protected] We’ll provide you with a pre-consultation questionnaire that will help you get maximum value out of your time. The next move is yours. Make it and it’ll make all the difference. We guarantee it.