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Tax, SDIRAs & Cost Segregation

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Christine Oliphant
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  • Gainesville, VA
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Question about tax free earnings with SDIRAs

Christine Oliphant
  • Real Estate Investor
  • Gainesville, VA
Posted Apr 2 2014, 21:48

I've been learning about SDIRAs and from what I understand when you use the money in your real estate business, the money you earn will be tax free. So as Amanda Han put it in podcast 49, if a wholesaler puts a $1,000 earnest money deposit down and then makes $10K from the deal, those earnings are tax free.

Does this also apply when you fix and flip a property? So if you buy a property for $50K and end up with $30K in profit, those earnings are not taxed?

It doesn't seem like that could be the case since people are doing 1031 exchanges but I'm just trying to figure out the best avenue to save on taxes for fix and flip deals.

Am I understanding this correctly?

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Adam Hershman
  • Las Vegas, NV
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Adam Hershman
  • Las Vegas, NV
Replied Mar 24 2015, 10:02

@Joshua MassariIt is very rare to have a blocking C corp in a SDIRA simply because the amount of UBIT generated would have to be pretty massive to outweigh the benefits of the LLC acting as a disregarded entity for the IRA.

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Daniel Dietz
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  • Rental Property Investor
  • Reedsburg, WI
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Daniel Dietz
Pro Member
  • Rental Property Investor
  • Reedsburg, WI
Replied Mar 24 2015, 10:08

Great discussion. 

One thing I did not see in the tread (I 'speed' read it) is in regards to the 'labor' for flipping in a SDIRA. Disclaimer - I DONT do flips in my SDIRA because of my understanding of what I am about to say, I do buy-n-hold rentals.

In a SDIRA, there can not be any 'self dealing' which in short means benefiting you or any lineal relatives... kids, parents, spouse, grandkids, etc... (this is the simplified version). So IF you were planning on doing the labor yourself, or having a son, grandson, father, etc... do any of that, it is a big no-no, as YOU personally would be 'benefiting' your SDIRA (which is a separate entity from you personally). Think of it as if 'you' did the labor and profited 50K, that would be the same as making a 50K 'contribution'.... big no-no.

In my case, if I do a flip, *I* would want to do at least part of the labor as I am in the  construction business for my 'day job', which is why I would choose to do it outside on my SDIRA.

Dan Dietz

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Adam Hershman
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Adam Hershman
  • Las Vegas, NV
Replied Mar 24 2015, 10:25
Originally posted by @Daniel Dietz:

Great discussion. 

One thing I did not see in the tread (I 'speed' read it) is in regards to the 'labor' for flipping in a SDIRA. Disclaimer - I DONT do flips in my SDIRA because of my understanding of what I am about to say, I do buy-n-hold rentals.

In a SDIRA, there can not be any 'self dealing' which in short means benefiting you or any lineal relatives... kids, parents, spouse, grandkids, etc... (this is the simplified version). So IF you were planning on doing the labor yourself, or having a son, grandson, father, etc... do any of that, it is a big no-no, as YOU personally would be 'benefiting' your SDIRA (which is a separate entity from you personally). Think of it as if 'you' did the labor and profited 50K, that would be the same as making a 50K 'contribution'.... big no-no.

In my case, if I do a flip, *I* would want to do at least part of the labor as I am in the  construction business for my 'day job', which is why I would choose to do it outside on my SDIRA.

Dan Dietz

 Hey Dan, 

You are absolutely right, once you put an asset in your SD IRA, you have to become a hands off party to that asset, and so will certain family members. The thing to remember in this case, and why a lot of contractors, and people in the construction business just like you, are using a SD IRA to flip homes (not that I am advocating for or against it) is because they know the business. They are the people who are best poised to make a decision on how much it will take to fix the house, and how the finished product will affect the price of the house. This also means you can negotiate with contractors you hire to work on the house from a better position, the average homeowner or RE investor relies heavily on a contractors price bids. You on the other hand would be able to see exactly where a contractors mark up or profit would be in a proposal, and work to minimize it (and therefore maximize your return).

So yes there are a lot of people, like you, who do this outside of the IRA to be able to contribute "sweat equity" so to speak to improve the house, but there is no reason you can't do the same thing in your SD IRA with less time investment, and if you think about the hours you pay yourself to do the work in the non retirement assets, you'll find that hiring someone in a tax sheltered asset vs doing the work yourself in a non sheltered asset, works out to be pretty similar returns. 

Basically, if you think flipping homes is the best return on your personal money, why wouldn't it also be the best return on your retirement money as well? Why not do it in both?

Just something to keep in mind.

Adam

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Joshua Massari
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  • Costa Mesa, CA
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Joshua Massari
  • Rental Property Investor
  • Costa Mesa, CA
Replied Mar 24 2015, 10:26

Thanks @Daniel Dietz. I am actually looking into turnkey out of state fix and flips using someone else to handle everything and just paying them an organizing fee for putting everything together. I would only be taking title through the SDIRA and paying the contractors, organizer fee etc., but not being involved in any of the manual labor. According to the IRS you can get nailed for doing as little as changing a lightbulb and I definitely don't want to push the envelope. 

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Joshua Massari
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  • Costa Mesa, CA
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Joshua Massari
  • Rental Property Investor
  • Costa Mesa, CA
Replied Mar 24 2015, 10:31

@Adam Hershman - thanks for the input. I would actually prefer to do this outside of an IRA especially if I'm paying capital gain tax via the UBIT. But the only reason I'm looking at doing this is because I already have a chunk of change in an IRA through my employer so I would rather get the higher returns as opposed to mutual funds. I'm also working on a HELOC to do the same type projects without the money being in a retirement account.

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Adam Hershman
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Adam Hershman
  • Las Vegas, NV
Replied Mar 24 2015, 10:46
Originally posted by @Joshua Massari:

@Adam Hershman - thanks for the input. I would actually prefer to do this outside of an IRA especially if I'm paying capital gain tax via the UBIT. But the only reason I'm looking at doing this is because I already have a chunk of change in an IRA through my employer so I would rather get the higher returns as opposed to mutual funds. I'm also working on a HELOC to do the same type projects without the money being in a retirement account.

 I get what your saying. If you're going to pay taxes on profits, you don't then want those assets in an account that you will later have to pay taxes on again. That isn't exactly how the UBIT works, and it is more a tax because you are using a strategy that the IRS considers a business to hopefully make a higher return and offset the taxes. But I can certainly understand not wanting those funds to be taxed twice. 

One other thing to remember $100,000 in your IRA cost you $100,000 to aquire; $100,000 post tax funds cost most people around $125,000 to acquire, while you do have to pay those taxes later, it is more capital to invest in the meantime.

Adam