You are probably wondering what that title means?
People have been investing in Real Estate forever – it has created more millionaires than any other type of investing. Real Estate investments can create wealth by generating regular rental income, depreciation, long term capital gains and utilizing 1031 exchanges. That is not an exhaustive list, but a good beginning to understand why Real Estate investments are different.
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However, sooner or later someone will have to pay the piper and the piper’s name is Uncle Sam. What if there was a way to take advantage of what Real Estate investments offer and keep Uncle Sam out of the picture.
Since 1974 investors have been able to use Self-Directed IRA’s to purchase Real Estate. Today almost 90% of our clients want to use self-directed accounts to directly or indirectly invest in Real Estate. By using a self-directed IRA, your rental income and eventual gain on the property are tax deferred until later in life. Later in life rears its head the April after an IRA owner turns 70 ½. That is when RMD’s kick in and Uncle Sam begins to recoup his taxes. BUT, at least you could delay them for a long time.
ROTH IRA’s changed all that. ROTH IRA’s are funded with after tax contributions. We will refer to these contributions as “seed money”. The ROTH IRA owner invests in Real Estate, collects rents and eventually realizes a profit upon the sale of the property. The rents and the gain are tax sheltered but once the ROTH has been in existence for five years, and the ROTH owner reaches the age of 59 ½, the tax deferment changes to TAX FREE. We will call this “the harvest”. Uncle Sam in outside in the cold. The ROTH owner, his heirs or beneficiaries will never have to pay income tax and that is a good thing.
Bonus Round – using leverage in a self-directed IRA to purchase real estate. By utilizing a non-recourse loan, the IRA owner can leverage his investments and instead of buying just one rental, he can buy two. Now there are two sets of rents and two profits to realize. Sounds good and it is BUT the IRS will come along and tell you all about UBIT – unrelated business income tax. The percentage of the net rents collected and the gains derived from the borrowed monies will be taxed at corporate tax rate. So if you leveraged 50% then 50% of the gains would be subject to the tax. But at least you made more than just having one rental.
Bonus Bonus round – so far we have only talked about self-directed IRA’s. How about self-directed 401k’s? About 60% of our first time callers or people who visit our website want to learn how to invest in Real Estate using a self-directed IRA. After we talk with them, we “graduate” most of them to a self-directed 401k v.s. a self-directed IRA. There are many reasons we do this but for the sake of this blog, let’s concentrate on “the Holy Grail”.
Since 2006, we have been able to incorporate ROTH into the self-directed 401k plans we create for our clients. Our ROTH 401k clients are also able to utilize non-recourse loans to purchase Real Estate the same as our self-directed IRA clients can.
Guess what? UBIT does NOT apply to leveraged real estate transactions inside properly structured self-directed 401k! It does apply with self-directed IRA’s but not self-directed 401k’s. This is huge – now you can see why once we learn a potential client wants to purchase Real Estate, we graduate them to self-directed 401k’s.
Imagine – you have a $50,000 ROTH self-directed 401k, you utilize a $150,000 non-recourse loan and buy a $200,000 rental. The Holy Grail has just arrived. No tax on the rents, no tax on the gains, UBIT doesn’t apply, your ROTH is 5 years old and you are over 59 ½.
Rick Pendykoski is the owner of Self Directed Retirement Plans LLC, a retirement planning company based in Goodyear, AZ. He has over three decades of experience working with investments and retirement planning, and over the last ten years has turned his focus to self-directed ira accounts and alternative investments. If you need help and guidance with traditional or alternative investments, call him today (866) 639-0066.