Buy and hold in an IRA - Pros and Cons
Investor · raleigh, NC · Member since 2016 · 13 posts · 1 vote
Does anyone have experience holding property from a self-directed IRA? I am trying to get a handle on what is possible, and the pros and cons? For example, can I use IRA funds for a down payment, or must I make an outright cash purchase? How are cash flows treated? If I later sell the property, is it cap gains or ordinary income?
Thanks in advance for your thoughts and experience.
If the IRA has enough funds, it can purchase the property outright. All income and expenses would flow through the IRA. The income would continue to grow on a tax deferred basis. Once IRA distributions commence (generally at retirement age or once RMDs apply), that is when Uncle Sam will collect the income taxes.
If you don't have enough funds in the IRA for the full purchase, the IRA can obtain a non-recourse loan. For a list of lenders see the following:
However, when an IRA utilizes debt financing for investing in real estate, UDFI applies. See following for more on this.
Therefore, if you plan to use a non-recourse loan, it may be best to open a solo 401k instead as UDFI tax does not apply to solo 401k plans. To qualify for a solo 401k, you must be performing at minimum part-time self-employment and have no full-time W-2 employees.
Following are the similarities and differences between the solo 401k and the self-directed IRA.
The Self-Directed IRA and Solo 401k Similarities
The Self-Directed IRA and Solo 401k Differences
If the IRA has enough funds, it can purchase the property outright. All income and expenses would flow through the IRA. The income would continue to grow on a tax deferred basis. Once IRA distributions commence (generally at retirement age or once RMDs apply), that is when Uncle Sam will collect the income taxes.
If you don't have enough funds in the IRA for the full purchase, the IRA can obtain a non-recourse loan. For a list of lenders see the following:
However, when an IRA utilizes debt financing for investing in real estate, UDFI applies. See following for more on this.
Therefore, if you plan to use a non-recourse loan, it may be best to open a solo 401k instead as UDFI tax does not apply to solo 401k plans. To qualify for a solo 401k, you must be performing at minimum part-time self-employment and have no full-time W-2 employees.
Following are the similarities and differences between the solo 401k and the self-directed IRA.
The Self-Directed IRA and Solo 401k Similarities
The Self-Directed IRA and Solo 401k Differences
Good Morning @Jason Deck!
If you were to purchase property with your SDIRA the down payment would also have to come from the IRA funds. If you were to purchase it, your IRA would be ineligible to have that property since your personal funds were used to hold it.
All funds needed for the property would need to come from the IRA as well. This includes but isn't limited to taxes, utilities, and repair bills. All proceeds from the property would go back to your IRA, such as rental income or the income from a sale if you were rehabbing the home.
If your IRA does not have enough funds and you are still looking to do something along these lines, you could partner with a non-disqualified party or obtain a non-recourse loan.
@Lance Lvovsky Does it matter, given that the cash flows are tax-free anyway?
Much of the information above is helpful.
The key to investing an IRA in real estate is to determine if the risk/reward equation is better than other investments you can make with the IRA. Your point above is well stated, and I am often needing to remind folks on BP that one is not comparing real estate in an IRA to real estate held personally (the tax situation is so different), but rather to what other options the IRA may have for investing.
As noted, the IRA can leverage with a mortgage. This introduces the risk that the IRA must pay the mortgage every month whether there is rent coming in or not. The use of debt-financing also introduces a small tax known as UDFI. This adds the complexity of book keeping and the expense of the tax return that would not be necessary with an all cash purchase by the IRA. The bottom line, however, is that the IRA should receive a higher cash-on-cash return due to the use of leverage, so these complications can be well worth it with the right property managed the right way.
When the property is sold there is no taxation on the transaction if there is no mortgage in place. The IRA is simply being reallocated from holding real property to holding cash. If there is still a mortgage balance, then UDFI taxation will still apply, with the capital gain associated with the debt-financed portion of the deal taxed at 20%. Again, the IRA is still coming out ahead relative to an all cash purchase on the same property.
If you are self-employed with no full time employees, the Solo 401(k) plan option would eliminate the concerns of UDFI tax on a leveraged investment. Our say on that topic is that the tax is not so onerous as to justify squeezing into a Solo 401(k) if you do not truly qualify today and for the long haul.
@Jason Deck A few additional thoughts on this subject:
- Your IRA can partner with another IRA eliminating the need for a loan.
- You can also buy performing notes in an IRA, since the income would normally be taxable, keeping it in a tax deferred IRA is a nice plus.