Can Self-Directed ROTH IRA purchase R.E. with tax-free?

19 Replies

Hello BP Community,

How are you? Hope all is well! I'm a fairly new member on the BiggerPockets.

I just have a question for you regarding how to use a ROTH IRA funds to purchase real estate properties. Since all funds and capital gains are all growing tax-free inside of a ROTH IRA account. My questions are:

1.) IF we used ROTH IRA funds to buy a real estate property. Let's say if we purchased it for $100K and we held onto that property for 20 years and it grows to like $500K. Since we initiated the sale with using ROTH IRA funds to fund the deal, would the $400K capital gains be tax-free if we choose to sell it when we hit the legal retirement age?

2.) With the above example, IF we used $30K from ROTH IRA account to fund a $100K deal to pay for the 20% down plus closing costs, and we use the investment property as a rental, would all the rental income be considered TAX-FREE when we collect the monthly rentals? Not sure if the ROTH IRA tax-free funds being used to purchase the rental property will flow down to the rental income being collected each month.

Those are my 2 main questions regarding funding from ROTH IRA to purchase real estate properties.

Thank you very much in advance for your time! 

Best Regards,

Phong

@Phong Lam , congratulations on your first forum post!

Roth IRA is tax-deferred vehicle. When you sell investment inside of a tax-deferred vehicle you are not taxed. Distributions from Roth IRA come out tax free (if you meet the criteria, which you are based on your scenario).

Since you are using leverage inside of an IRA, some of the income will be considered Unrelated Business Taxable Income (UBTI) and therefore will be subject to UBIT (Unrelated Business Income Tax).

As a real estate agent you are considered to be self-employed, therefore qualify for truly self-directed Solo 401k plan. It has number of advantages over self-directed IRA, such as being exempt from UBIT on leveraged real estate and large contribution limits that are 10 times higher than an IRA. You should consider this vehicle instead, although if you have funds in existing Roth IRA you would not be able to transfer those into Solo 401k.

Hello and Welcome,

My answers 1. NO, 2. No 

Idea is to move it to a self IRA.

Hint find an accountant or someone who knows about retirement funds and how they work.  

Big surprise is the average of the 5 years before you retire number and the amount that you can take out of the investments you have and not get taxed. 

In very simple terms you make an average of 50k the last 5 years.  You retire, you think I can take out 100k every year for the next 20.  And then tax time comes around and whamo you owe 66k. oops...

The rule goes like amounts so if you make 50k a year you can 50k a year before you get taxed.  Also you have to take a certain amount out after a certain age and that is not negotiable and if it is over the average whamo taxes due. 

These numbers are not exactly how it works but you need to figure it out before you get to 65.

@Michele B.

Your statements above do not apply to a Roth IRA, only to a tax-deferred IRA.

@Phong Lam

Welcome to BP.

@Dmitriy Fomichenko did a pretty good job of covering the basics.

If the savings you have is currently in a Roth IRA, then a self-directed Roth IRA would be your only transfer option. A Solo 401(k) would also be worth looking at if you are considering but have not yet converted to Roth, or as a means to set aside future contributions from your self-employment income.

In a self-directed IRA, it is still an IRA, just with different choices on the investing side and a whole lot more control than conventional IRA accounts.

An IRA may invest in real estate, whether all cash or with a non-recourse mortgage.

The IRA is on title to the property. All expenses must be paid from the IRA and all income flows to the IRA.

The income from rents is typically tax-sheltered into the IRA, much like earnings in the stock market. An exception in the IRA world is if leverage such as a mortgage is used, in which case a small tax applies to the percentage of the income attributable to the non-IRA (borrowed) money. The tax amount and rates are generally pretty nominal, so consider this a small cost to reap the benefits of leverage and a higher cash-on-cash return for each IRA dollar invested. Something to understand, not fear.

At the time of sale, the IRA is essentially just reallocating from holding real property to holding cash. It is a non-event for tax purposes (unless there is still debt in place).

When you take money out of a Roth IRA, that will be non-taxable to you.

Hi @Brian Eastman! Thank you very much for your input as well! Greatly appreciate it! 

So when you refer to "Non-Recourse Mortgage", is that where a mortgage company gives you a mortgage that allows you to use the name of the IRA as a "Buyer's Name" for the title & mortgage? Let's say for example, IF I have $30K saved in a ROTH IRA account and then rolled that over to a self-directed ROTH IRA. I can do a 20% down conventional mortgage plus closing costs and finance 80% of the loan through a "Non-Recourse Mortgage"? And I'll have to buy the rental property with the "Self-Directed ROTH IRA Account Name"? Can I refinance this particular rental property later on and put that tax-free equity loan money back into the self-directed account to purchase more rental properties tax-free?

How about if and when the rental property needs minor repairs and so forth, do I pay the repairs with my personal funds first and just gather up a TOTAL by year's end and then reimburse myself out of the SD ROTH IRA?

And god forbid if there are situations where there is an eviction is needed and needing attorney fees to do the eviction process and so forth to get rid of the unwanted tenants, can we use our personal funds to get rid of the tenant? 

Let's say IF the Cash Flow generates $12K per year, that's all tax-free rents that needs to go back into the SD ROTH IRA, is that correct?

And once I hit Age 59 1/2 and the property grows from $100K to $500K that is held in the SD ROTH IRA, IF I sell the property by that time, the $400K capital gains would be all tax-free, is that correct?

On another note, IF I have a 100% equity on that $500K property, how can I use the equity to acquire more properties without selling the current property? Let's say if I want to just use $100K of the equity, how can I take out this money to re-invest in more properties inside the SD ROTH IRA?

Many thanks in advance! You guys are awesome with your wealth of knowledge in this forum! 

Best Regards,

Phong

@Phong Lam

A non-recourse loan allows your self-directed IRA or 401k to borrow funds in connection with an investment WITHOUT you needing to sign a personal guarantee for the loan. You are unable to guarantee any loans to your retirement account since you are considered a disqualified person.

@Phong Lam ,

If your IRA owns the property, IRA must pay for all expenses related to the property. You would not be allowed to use any personal funds in connection with the property owned by the IRA - that would violate IRS rules.

Since you personally as "disqualified person" are not allowed to guarantee the loan on a property your IRA is buying, you can not use conventional financing, the loan must be "non-recourse". There is handful of lenders who specialize in this type of financing to retirement accounts, since this type of loan presents higher risk to the lender typically you will be required to come up with 30-40% down. I compiled the list of lenders here:

https://www.biggerpockets.com/blogs/2810/50272-lis...

When your IRA buys the property, the custodian will take the title to the property for your benefit (unless you are using Checkbook IRA in which case the LLC will hold the title). Truly self-directed Solo 401k does not require a custodian, all plan assets would be held in a 401k trust, as trustee of the trust you would be in total control without having custodian on the middle. You can learn a lot from this discussion on the subject of self-directed Solo 401k:

https://www.biggerpockets.com/forums/51/topics/527...

If you own free-and-clear real estate in your retirement account you can do a cash-out-refinance and leverage the equity to purchase more investments. As I mentioned earlier debt finance will trigger UBIT in an IRA (Solo 401k would be exempt from UBIT on leveraged real estate).

@Phong Lam

Great info on this forum from the BP IRA/401k pros.

Conceptually, you must be aware of the following when using tax-advantaged retirement accounts for real estate investing:

Who is the investor? Your IRA/401k is the investor, not the IRA-holder. View the IRA/401k as an entity that is independent of yourself over which you have authority.

Prohibited TransactionsIn general, you - as an individual - you should not be a party to any transaction to which your IRA/401k is a party; you should act strictly on behalf of the IRA/401k. The requirement that you not personally guarantee any loans taken by your IRA/401k is a corollary of this rule.

UBIT/UBTI/UDFI: Traditional IRAs/401(k)s are tax-deferred and Roth IRAs/401(k)s provide tax-free earnings - with regard to "regular" income tax. However, in some scenarios they are subject to a "special" type of income tax that applies to all tax-advantaged entities: UBIT.

What do these stand for?

UBIT = Unrelated Business Income Tax: This refers to actual IRA tax liability; the amount that it owes to the IRS, based on compressed trust tax rates.

UBTI = Unrelated Business Taxable Income: This is the type of income that generates UBIT liability.

UDFI = Unrelated Debt Financed Income: This is subset of UBTI.

  • A leveraged real estate deal may-or-may-not generate UDFI. There are available deductions and exemptions that mitigate the tax exposure.
  • Gain upon sale of a leveraged IRA asset is taxed at normal capital gains rates. The extent to which the gain is taxable is based on UDFI calculations. The rate at which such income is taxed is the cap gains rates.

Solo 401k simplifies this, as it's exempt from UDFI on real estate acquisition indebtedness.

@Derek Wissner ,

Solo 401k is only exempt from UBIT on income from leveraged real estate (Internal Revenue Code Section 514(c)(9)). It would not be exempt from UBIT on income from business activity. 

@Derek Wissner

A clarification is in order.

All tax exempt entities are exposed to certain taxation in certain circumstances; when they engage in a trade or business on a regular basis, or when they utilize debt-financing.

The taxable income generated from those activities are UBTI (unrelated business taxable income) and UDFI (Unrelated Debt-Financed Income), respectively.

The tax paid is UBIT (Unrelated Business Income Tax)

A qualified employer plan such as a 401(k) is generally subject to tax on debt-financed income.  However, there is an exemption for debt-financing associated with the acquisition of real property.  I don't have a code reference handy, but IRS publication 598 which covers UBIT related topics does note this exemption.

So, a Solo 401(k) is not broadly exempted from UBIT.  The exemption is purely on UDFI stemming from mortgaged real estate investments.

@Brian Eastman I believe I'm following you. I have two SDIRA's investments now and am considering a third. This one would be a share of an LLC that would own several multi family properties. It, the LLC, would have debt. If I owned a percentage of the LLC and it was, say, 80% leveraged, wouldn't my UBIT would be bases on 80% of the income.

@Derek Wissner

Yes, 80% of the your IRA's share of the income generated by the LLC would be considered UDFI and therefore taxable.

You would then apply a $1000 exemption and 80% of your IRA's fractional share of the normally allowable deductions such as depreciation, interest on the note, etc., to reduce the taxable income.

The resulting net taxable income is then run through the trust tax table to determine the tax amount.

Generally speaking, while there is the UBIT cost associated with the use of debt-financing in an IRA, the net after-tax return should still be better in a leveraged scenario than an all cash scenario.

Many thanks to everyone's  invaluable advice and inputs here in this thread! You guys are awesome!!! Thanks a bunch! It is greatly appreciated! 

Phong,

1- The beauty of using your Roth IRA is you can get all growth tax free if you have a Roth for 5 years and a gualifying reason(ie 59.5). If you meet both you get your $400k of earnings completely tax free! You just have to be careful that your real estate investment is an arms length transaction and not self dealing or the IRS could view as a prohibited transaction and you could lose your tax benefits.

2- If you use your Roth IRA to leverage real estate that could result in the Unrelated Business Income Tax (UBIT). That portion would be subject to tax.

If you do decide to choose real estate within your IRA or a SOLO 401k you should consider using a custodian that specializes in alternative investments in retirement vehicles such as Provident Trust Group that can help you navigate through the nuances..