Editors' pick: Originally published June 30.
Self-directed individual retirement accounts are catnip to real estate investors.
These special IRAs allow investors to deploy their retirement capital into real estate and to enjoy the substantial tax benefits offered by IRAs. But in some cases, using a self-directed IRA for real estate investments can hurt investment results.
Here are five devastating traps awaiting real estate investors who use self-directed IRAs:
Trap 1: Punishing taxes
IRAs eliminate taxes on investment profits, right? Alas, the truth is different from the fantasy.
Roth IRA holders have the best tax advantage ever created: The profits are 100% tax-free, and that advantage is impossible to beat.
But what about traditional IRAs, which are tax-deferred rather than tax-free?
This is a highly relevant consideration because there is far more money in traditional accounts than in Roth accounts. Does the tax deferral of a traditional IRA outweigh the tax advantages of owning real estate outside an IRA?
Generally speaking, the traditional IRA isn't tax efficient for real estate.
Real estate investments executed outside an IRA are usually taxed at long-term capital gains rates, which are relatively low at 15% to 20%. But if the same transaction happens in a traditional IRA, the investor's profits will be hit with ordinary income tax rates during retirement, and those rates are as high as 39.6%.
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 higher ordinary income tax rates.
Trap 2: Cash purchases only; no leveraged purchases
Using debt to purchase real estate is one uniquely wonderful reason that savvy investors prefer real estate as an asset class. But in some very tangible ways, debt inside an IRA profoundly diminishes the tax benefits.
The law doesn't prohibit an IRA from borrowing money. But doing so opens up an IRA to current tax liabilities, as the Internal Revenue Service categorizes income that results from debt in an IRA as business income, rather than investment income.
As a result of this fine-print distinction, an account could be hit with a particularly nasty tax called unrelated business income tax, which could chop another 39.6% off of profits, which would be due on the present-day tax liability.
Trap 3: Non-IRA tax advantages disappear
Real estate may be the most tax-favored asset class. Even without the benefit of an IRA, real estate offers a ton of tax-reducing potential that can have an immediate impact on the investor's income tax burden.
The two biggest examples are the 1031 exchange and real estate depreciation. The former allows investors to defer taxes on real estate profits indefinitely by reinvesting those funds into other real estate, while the latter allows some investors to substantially reduce their income tax burden.
Unfortunately, those tax advantages are unavailable to an investor when it is his or her IRA doing the investing. The IRS views an IRA as a distinct entity from the holder, and even if the activities of an IRA would merit tax advantages if performed outside an IRA, the execution of the transaction inside an IRA means that those advantages aren't available to the investor.
Trap 4: 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, achieving maximum profitability 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 increase their equity at minimal cost.
However, the IRS sees it very differently, viewing an investor's 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.
Trap 5: 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. Although an investor is allowed to invest in nearly any asset class, the rules governing IRAs are very strict, inflexible and wholly unforgiving.
What does it take to break those rules? It is easier than one might think.
Each of the following actions is arguably prohibited for a IRA-owned property:
- Paying any bill connected with an IRA's property with personal rather than IRA funds
- Allowing a boss, colleagues or family to use an IRA's beach-front property
- Allowing one's granddaughter's Girl Scout troop to sell cookies on property owned by the IRA
There is an untold number of ways to unintentionally commit a prohibited transaction, and the IRS has become aggressive recently in identifying these transgressions, as the payoff for them can be huge. It is very plausible that committing any prohibited transaction could result in an IRA value being slashed by 50% to 100%, and there is no simple way to fix these errors.
Despite these risk factors, real estate investors shouldn't automatically avoid self-directed IRAs. There are many excellent reasons for real estate investors to use self-directed IRAs as discussed in this podcast.
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 one's financial security during retirement.
This article is commentary by an independent contributor.