Many people choose to invest in real estate so they can benefit from the tax advantages and also diversify their portfolio. While there are a number of tax incentives that can be used during the time you own a piece of real estate, when it eventually comes time to sell, you can be hit with some lofty taxes.
However, there are ways to invest in real estate without paying any tax on the gains you make -- or to possibly defer taxes to a later date. These strategies are available to almost anyone and can save tens of thousands, or hundreds of thousands of dollars in taxes each year.
It's important to note that many of these tactics, such as investing in a self-directed IRA, Solo 401k, or HSA, are long term strategies. You can invest in real estate with these vehicles tax-deferred or tax-free, but you will need to wait until retirement to withdraw the funds to avoid penalties. Let’s explore what these options are and how each of them works.
Self-directed IRA (SDIRA)
An individual retirement arrangement (IRA) first became available as a part of the Employment Retirement Income Security Act of 1974. It was intended to encourage individuals to build a more stable financial future and retirement fund by growing money tax-free in a Roth IRA or tax-deferred in a traditional IRA.
What investments do IRAs cover?
IRAs are limited to traditional investments that are traded on or related to the stock market. These include stocks, bonds, mutual funds, annuities, exchange-traded funds (ETFs), and real estate investment trusts (REITs) … really anything traded on the stock market. They do not include alternative investments like real estate, businesses like partnerships or LLCs, precious metals such as gold or silver, cryptocurrency, hedge funds, and oil and gas, among other assets. That is unless you have a self-directed IRA (SDIRA).
What's a SDIRA?
A SDIRA is similar to a normal IRA but allows you to invest in alternative asset classes such as real estate. With a self-directed IRA, you can invest in real estate assets such as:
You can elect to have a Roth self-directed IRA which means you pay taxes when you contribute money to your IRA rather than when you withdraw it. This means your cash will grow tax-free. The other option is a traditional SDIRA, which defers your taxes. In a traditional SDIRA, you do not pay taxes when you contribute, but instead pay taxes when you make a withdrawal.
Out of the two, a Roth SDIRA offers the best tax advantages because you pay taxes on a smaller amount of money at the point when you invest it. I personally would much rather pay taxes on $6,000 now than pay taxes on $15,000, $25,000 or more in my retirement years. Not to mention that the chances of our tax rates decreasing are pretty minimal -- it’s much more likely that they will increase in the future. Ultimately you never know what you may have to pay 10, 20, 30, or 40 years from now, so why not pay taxes on less money now?
Let’s give you an example of how this could work:
- You find an off-market duplex for sale and purchase it with your Roth SDIRA for $195,000.
- You keep the rental for 20 years, receiving an average of $1,400 per month in net cash flow which equates to $336,000 in net rental income collected over the 20 years. For simplicity I’m not accounting for rental increases, vacancies, or ongoing maintenance costs. Since your Roth IRA owns this investment, all that rental income is paid directly to your SDIRA and is completely tax free.
- You then decide to sell the property for $375,000. $375,000 for the sale plus $336,000 in rental income comes to $711,000.
- That means you have made on $516,000 your initial $195,000 investment, completely tax-free!
If you conducted this same transaction in a traditional SDIRA, you would end up paying tax on the $516,000 instead of the $195,000. See why paying taxes on less is typically better?
Contributions and withdrawals
Currently, if you are under the age of 50, you can contribute up to $6,000 per year into an IRA and an additional $1,000 if you are 50 or older. The April after you turn 70 and a half, there are required minimum distributions (RMDs) -- amounts that you must withdraw -- that are mandated by law. If you want to see how much your RMD would be based on your investment account and age, you can use an online retirement calculator to get a rough idea. There also are certain thresholds that may limit how much you are able to contribute to your SDIRA, or even disqualify you from having one to begin with.
SDIRA participants can withdraw funds at any time after the age of 59 1/2 without penalty. Any withdrawals before that may be subject to a 10% penalty. If it is a traditional SDIRA, each year the total distribution made from the account is taxed as regular income. If it is a Roth SDIRA, as long as the account has been open at least five years and your withdrawals don’t exceed your earnings, you are able to take withdrawals before 59 1/2 in certain circumstances.
Opening a SDIRA
There are a number of IRA companies that specifically offer SDIRA plans such as the Entrust Group, NuView Trust, Quest Trust Company, or American IRA. It’s important to find out what their annual fees are, whether there are any fees for creating a new account, and what their process is like for funding an investment. Some move more slowly than others so ask around for client feedback and speak to other SDIRA account holders about who they use and why.
You can either start a new account and start making the maximum annual contributions based on your age and income or, if you already have an established IRA, you can rollover your current account into a same-kind SDIRA without any tax penalties. That means a Roth IRA would become a Roth SDIRA and traditional IRA could become a traditional SDIRA.
Self-directed IRA companies will have a custodian to assist you with the required paperwork and approval of each investment within your IRA. Custodians are not financial advisors and do not give advice on which assets to invest in or not invest in, but instead keep you compliant with SDIRA rules and regulations. You can also choose a plan that offers checkbook control, in which you bypass the required approval of a custodian.
While most SDIRA companies do their best to review and authorize each transaction as quickly as possible, it’s not uncommon for funding to take several days or weeks. Many people prefer having checkbook control because transactions are processed at a much faster rate and often cost less because there are fewer people involved in the transactions. However, having checkbook control means you are liable for any prohibited transactions and are responsible for maintaining proper records of every investment and transaction. It’s up to the individual to see which option best fits their needs.
There are certain restrictions called prohibited transactions that must be avoided if you are investing with a SDIRA. If the investment directly transacts with a disqualified person, it would be considered prohibited and should not be done with your SDIRA.
A disqualified person is:
- Your spouse
- Your lineal descendants (children or grandchildren)
- Your lineal ascendants (parents or grandparents)
- A financial or legal professional who advises you in a fiduciary capacity
- Any business entity that any of these individuals’ control
This includes lending money to them, buying an asset with them or for them, or using your SDIRA funds to work with them in any capacity. So, you can invest in a real estate venture with your sister, brother, cousin, or niece, but not your parents, daughter, or son. You could buy a rental investment and rent it to your brother or sister, but you couldn’t rent it to your daughter, granddaughter, or father.
Your SDIRA would also not be able to "buy" an investment you already own or have an interest in because you are directly tied to the transaction. Most custodians advise only investing in opportunities that are considered arm’s-length transactions, meaning your direct interaction with the investment is minimal (you don’t renovate the home yourself but hire a third-party company to do the renovation).
It’s also very important that your SDIRA is responsible for paying all costs associated with the transaction. You do not want to pay a utility bill, buy materials from a hardware store, or pay for any other costs associated with the property from your own personal or business account and have your IRA repay you. This could potentially be construed as self-dealing since you, a disqualified person, are paying for things associated with the transaction.
Participating in a transaction with a disqualified person or not following the guidelines for SDIRA puts your whole IRA in jeopardy. If caught, the IRS could potentially disallow your entire IRA, meaning you have to make a withdrawal of the entire amount while paying fees and penalties, and losing out on any tax advantages you once had.
Having a SDIRA can allow you to gain higher-than-average returns that are secured by alternative asset classes. Instead of being limited to the volatility of the stock market, you can diversify your portfolio and find opportunities that offer a higher return on investment. This avenue of tax-deferral or tax-free retirement growth is still a relatively new concept, but it’s an investment vehicle that should not be overlooked. There are far more positives than negatives in having a self-directed IRA, especially if your goal is to invest in real estate.