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.