Tax Tradeoffs to RE in sheltered account

[Parker T.]

All,

Correct me if I'm wrong, but if a property is completely owned inside a tax advantaged account (SD IRA or 401k) then we are unable to take full advantage of tax benefits to real estate investors, correct?

What if the deal is syndicated, for example, I have an SD IRA that contributes money to buy shares in ABC LLC, outside of an account. And ABC LLC buys/owns/maintains a property. Since the property is outside of IRA then all tax benefits would apply and then just owners profits flow back to the IRA? Sorry if this was worded in a confusing manner. And thanks for the help.

PT

[Jon Holdman]

Sorry, @Dmitriy Fomichenko but that's incorrect about depreciation. And, @Victor A. real estate owned inside a qualified plan, such as an IRA, can be subject to taxes.

What is true is that if you have net passive losses after accounting for depreciation on a deal inside an IRA that you cannot use those to offset your own ordinary income. But then 1) good rentals don't generate net passive losses, and 2) many folks who have enough to invest in rentals can't take advantage of those losses if they have them due to the AGI limits. The "tax advantages" of real estate are commonly oversold by sellers who are selling crummy rentals to naive investors.

Businesses owned inside an IRA are subject to "unrelated business income tax". It doesn't matter if the IRA owns it directly or if its indirect, such as an investment in an LLC. In @Doreen Chaisson's example, if that LLC was engaged in an active business and generating income, the portion of the income allocated to the units held by the IRA would create a UBIT tax burden for the IRA. The LLC would file a partnership return and send the IRA a K1. The IRA would need to file a tax return and pay tax on their share of the earnings. Note that actual distribution of cash to the IRA is irrelevant. If the LLC is retaining earnings, the IRA (and all other members) would still have the tax burden.

However, there is an exception to UBIT for rental properties. That income is not subject to UBIT. However, there is an exception to the exception and that is financing. If the property has a 65% LTV loan, then 65% of the income from the rental is subject to UBIT. That "debt financed fraction" changes over time. Each year you take the amount of debt (at the end of the year, I think) and divide by the basis. Basis goes down as deprecation is taken (or allowed, if not taken). Depending on the loan terms, the basis can go down faster than the loan balance so the debt financed fraction can actually increase during the early years of the loan. I've verified this with an attorney who specialized in IRA investments.

So, if you have a debt financed rental in your IRA you would have to pay UBIT tax on a portion of that income. To compute that you take all your gross income and subtract all your expenses including depreciation to get to a net income. Then multiple that by the "debt financed fraction". That income is subject to UBIT (or, more strictly UDFI - unrelated debt financed income tax.)

If its not a Roth type account, you're still subject to taxes when you take a distribution from the IRA.