recapture of depreciation in an IRA

[Scott Hurst]

I've been told that the IRS requires you to depreciate a residential rental even if it is in an IRA but you do not get to take the deduction. And, I'm told that you recapture the depreciation at 25% when you sell the property in the IRA so you don't get the deduction but you do have to repay when you sell. Can anyone confirm whether this is true? Thanks.

[Brian Eastman]

@Scott Hurst

Either what you have been told is entirely wrong, or being taken very much out of context.

If your IRA owns rental property all cash, there are no taxes on the income, which all accrue to the IRA tax-sheltered. The same is true when the property is sold. The gain is tax-sheltered under the umbrella of the IRA.

When you do not pay taxes on income, you do not claim deductions against those non-existent taxes.

If, however, an IRA purchases property using debt-financing such as a mortgage, it is now going to create some taxable income. The portion of the income that the IRA receives based on the borrowed money is considered taxable as Unrelated Debt-Financed Income (UDFI). So in a 60% LTV environment, 60% of the income is taxable.

The IRA now has taxable income, and therefore gets to use the same fraction of allowable deductions. So you apply 60% of things like depreciation, interest on the note, property taxes, etc. to reduce the tax burden the IRA will pay on the UDFI. For most investors, the final tax amount on rental income is negligible - maybe costing .25-.5% of overall return on investment from the deal - which the use of leverage kicked upwards in a much higher degree.

If debt-financing is still in place when the property is sold then the gain on sale is also treated as UDFI and taxable.  In the calculation for this capital gain, any depreciation used to offset UDFI on the operation of the property is then recaptured using the same logic as any other capital gain on the sale of real estate.

So, a leveraged real estate transaction gets a bit more complex and creates a small tax liability. This strategy is not for everyone. It can, however, really boost the return of your IRA through the benefits of leverage. I'll pay a few hundred dollars to my CPA and a few hundred to the IRS in order to magnify my returns by 30%.

The bottom line is that using an IRA to invest in real estate is not about tax efficiency as compared to investing in real estate with after-tax dollars. The same is true of any asset you may hold in your IRA, such as stocks, bonds, etc. The tax reality is just so entirely different. The reason that many investors choose to hold real estate in their IRA is because it is an asset class they know and understand, and can therefore produce better overall returns for the IRA than some other investment they may make with the IRA.