Why does tax law treat real estate investing the same as investing in old cars, baseball cards, antique dolls, coins and Hummel plates?
People have been investing in land since time immemorial, long before stock markets existed. Until lately, real estate has been a low profile, low risk way to accumulate wealth. The housing crash gave real estate’s reputation for reliability a black eye, but it also popularized the REO-to-rental business. Rising rents—which are still rising in most markets—created 8 percent returns on investment and cash flow derived from monthly rental payments that puts bucks in landlords’ pockets without requiring them to sell their assets, as do the vast majority of stocks, which pay no or negligible dividends.
Workers’ 401Ks are America’s piggy banks. The average 401K reached $84,300 during the third quarter of last year, up more than 11% from 2012. Workers who have been consistently contributing to a 401(k) plan over the past 10 years saw their average balance climb by 19.6% to $223,100 during the 12 months ending in June, 2013.
The vast majority of these folks who work for others have to jump through a half-dozen hoops if they want to use their hard-earned, tax deferred 401 K money to reap the kind of leverage, cash flow and returns on investment that have attracted millions to real estate. They would have to take a distribution or take out a loan from their 401K in order to invest in anything aside from the selections—largely mutual funds—offered by their plans, which are managed outside of their companies by plan sponsors who know virtually nothing about real estate. Few plans even include REITS or mutual fund REITS.
If you’re self-employed it’s easier. You can set up either a SEP IRA or a Solo 401K and use the proceeds to buy an SFR. With a SEP IRA, the most popular option, you must stay passive and can’t participate in the management of property at all. With the lesser known Solo 401K, enacted in 2002, there are no requirements to be passive, contribution limits are higher and you can even flip as well as hold. If an investor uses retirement funds to purchase real estate, then there is a potential tax liability called UDFI – Unrelated Debt Financed Income. This applies when the investor purchases the property. Like most other retirement plans, the SEP IRA is subject to UDFI. The Solo 401(k), though, is not subject to UDFI, a tax on the portion of profits that can be attributed to the amount of the investment that was leveraged when a mortgage or a loan was used in conjunction with the retirement funds.
Estimates of the number of self-employed vary from 10 and 42 million according to Bloomberg. That’s a lot of potential real estate investors, yet the numbers investing in real estate are probably only a miniscule percentage of the potential. (There are no hard numbers on how many self-employed are using their tax-deferred accounts to buy SFRs, but if you’ve got evidence to the contrary please leave a comment and I’ll concede the point.)
In light of the huge interest in real estate, why are so few investors using tax-deferred options?
I would respectfully suggest real estate investing has a serious image problem. Here’s an example where it’s hurting the industry directly in the pocket-book. Read the news coverage about investing in real estate, not the self-promoting blogs, this topic and here’s some of the comments you’ll find.
Buying real estate in any individual retirement account, including a simplified employee pension or SEP IRA, is a complicated process. The Internal Revenue Service has an extensive list of rules and regulations you must follow, and if you fail to observe all of them, your IRA may lose its tax-advantaged status, resulting in the entire IRA becoming immediately taxable to you.
In theory, yes, you can own rental property in a SEP-IRA. In practice, however, it can be a royal pain in the rear, not to mention an ill-advised choice.
Yes, you can buy real estate in your IRA, Roth IRA, or other retirement account. But it isn’t easy, Luscombe warns. In fact, it is quite complicated — and you’ll face many issues that might invalidate your IRA-based investment.
But there are so many complex rules and possible financial drawbacks to buying property through an IRA that it’s generally best not to do so. Bill Fleming, managing director of PricewaterhouseCoopers’ Hartford, Conn., office, says there are “millions of rules” placed on real-estate investments in qualified accounts that can make it not worth the trouble.
Had enough? You’ll note that most of these comments relate to SEP IRAs, still the most popular option. Almost no one in the mainstream media has written about using a Solo 401 to buy real estate, a good indication of how little awareness is out there.
So, with their clout with media and the politicians in Washington who control the tax code, the powers-that-be in Wall Street are doing an excellent job of convincing the average Americans to keep their bucks in bonds and stocks while they raid the real estate world with cash-flush hedge funds and REITS. For the average American Joe, one of the handful of new REO-to-Rental REITS may be the only way he will be able to participate in the opportunities offered by the REO-to-Rental business.
Photo Credit: zilverbat.