How do you handle depreciation in a self-directed IRA?

Question

A couple quick questions that hopefully someone has some experience with. I am looking at moving into a self directed IRA to purchase additional rental properties. Usually depreciation is one of the most valuable tax savings effects of rental properties when you ordinarilly own them but how is that handled with a self-directed IRA? If the account is growing tax free already are you still forced to take the depreciation out of your cost basis? If so, it would seem like it would be, in effect, a penalty since you do not get the tax benefits and your cost basis is reduced.

Does your cost basis even matter when you sell a property in your IRA since you are taxed as income when you withdraw from it in the future? Do 1031 exchanges even matter within an IRA?

Does your cost basis even matter when you sell a property in your IRA since you are taxed as income when you withdraw from it in the future?  Do 1031 exchanges even matter within an IRA?

Dmitriy Fomichenko · Answer

@Christopher Gilbert

because IRA is considered 'tax deferred' account, there is no tax benefits such as depreciation deduction when you buy investment property inside of it. This is one of the reasons why it is more advantageous to buy investment real estate in your personal name so that you can take advantage of the depreciation deduction for tax benefits and use your self-directed IRA to invest in other alternative assets such as trust deeds or mortgage notes.

Something else for you to consider is self-directed Solo 401k. As self-employed individual you have the ability to set up this plan and rollover your existing IRA or 401k in it and being investing. There are several advantages it has over IRA and one of them is being exempt from UBIT tax on leveraged real estate.

Myself and others have written extensively on this subject in the past so search the forum and educate yourself on the options that are available to you.

Loren Whitney · Answer

This is an age old question and a good one.

The great thing about using a retirement plan is that cost basis generally doesn't matter. You can buy a $100,000 property today for cash and sell it tomorrow or years later for a gain. There is no need to track depreciation and file for 1031 exchange. That is how things work when you pay CASH.

However, let's say you decide to finance your IRA purchase and put 50% down on a $100,000 property with a non-recourse loan. If you sell the property at a later date for a gain and still owe on that property, you will be subject to a tax called UBIT. I won't go into the calculations in this post but your debt financed profits are subject to UBIT and paid by the IRA. In this situation, your expenses and depreciation can be used to offset the UBIT tax. Furthermore, if you'd like to defer that UBIT tax, you can file for 1031 inside the IRA. In this example, you're simply deferring the tax that the IRA would have otherwise had to pay.

Feel free to follow-up with additional questions. I'll write you to connect as well.

Best of Luck!

Doreen Chaisson · Answer

This is correct - if the date of the sale of the IRA-owned property is at least one year and one day after the IRA's mortgage debt is paid off, there is no tax on the gain.

If your cash flow is neutral or negative, there would be no income to pay UBIT on.   UBIT is due on the UDFI  - unrelated debt-financed income - generated by a property (the portion of income attributable to the debt).  The first $1,000 of income generated is exempt.  If, after all deductions, your net income is $0 or less, you would have no UBIT due.

Jeff Rabinowitz · Answer

Real estate can still be very attractive inside an IRA (and even more so, inside a Solo 401K).  If you are planning an extensive rehab/renovation with a subsequent sale that forced appreciation is tax deferred (or tax exempt if held in a Roth).  Yes, you lose the depreciation but that is not very significant over the short time period you will probably hold the property.

Another example would be buying real estate in the path of development.  If you operate your rental property for a few years and then expect a windfall when your property is bought by a McDonald's, again the benefit of the gain being tax deferred will more than compensate for the loss of a depreciation deduction.Give serious thought to your exit strategies and how long of a period you plan on holding your assets before deciding which types of investments are best placed in which accounts.  If despite your proper planning a large gain develops in an account where you didn't expect it--well, if the account is self directed you still decide whether or not to realize the gain and unexpected gains are among the most pleasant problems you can have.

Regina Abayev · Answer

Definitely check on the disqualified parties and related transactions restrictions. The penalties are pretty severe for violations. Typically your sdira can't invest with your spouse sdira in the same transaction or LLC. Siblings are ok, but spouses, kids and I believe inlaws are not. I would call your administrator and ask to be safe.

Bill Gulley · Answer

Daniel, need to check with your fund administrator with respect to related transactions if you are partnering on deals.

Next, yes, expenses should be allocated to the property specifically as that reflects changes in your basis and income from that activity.

And, yes, depreciation will decrease the book value of assets for your net worth, unless you have an appraisal to show market value. :)

Daniel Dietz · Answer

Hello All,

Great discussion going here on this topic. On a slightly related topic of just holding properties in SDIRAs in general, I have a similar one.

So far we (3 way partnership - LLC) own two properties through our LLC, which is 1/3 owned by each of our individual SDIRA. We SO FAR have not borrowed at all for these properties, just all cash deals.

Since there is no 'debt financed' portion, I am wondering what we need to be doing as far as record keeping goes. Since we have not had to file a tax return for the LLC, we have not talked in depth with out regular tax guys at all yet.

Does it matter if small repairs or services hired get 'accounted to' a particular property the same way they would if outside of the SDIRAs? Should we be doing it the same way just to be safe?

Right now, the LLC has its own checkbook that ALL income and outgoes flow through, but the two properties are both in the same account.

Any advice would be appreciated.

Thanks, Dan Dietz

Regina Abayev · Answer

If I recall correctly, if you pay off the debt within your IRA more than 12 months prior to the sale of the property, then there is no tax on the gain.  Can someone confirm if that's correct?  Also, if you have a short term loan on the property, assume 5 or 10 year term, and you're cash flow neutral or os slightly cash flow negative, is the UBIT still a concern?

Mark Nolan · Answer

@Christopher Gilbert If you are planning to use debt financing when investing retirement funds in real estate, the Solo 401k may be be a better fit as it is not generally subject to UBIT like an IRA.

Dmitriy Fomichenko · Answer

As tax expert, @Steven Hamilton II should be able to explain this clearly.

How do you handle depreciation in a self-directed IRA?

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