Self Directed IRA/401k vs. 1031 and other conventional RE tax strategies June 24, 2008
Posted by Jeff Nabers in Self Directed IRA/401k, real estate.Tags: investment, self directed, 401k, real estate, invest, investing, income, tax, investor, taxes, gain, defer, 1031, like kind, exchange, retirement account, ira inflation, performance, depreciation, strategies
trackback
Conventional Tax Strategies for Real Estate
Many real estate investors boast of their tax strategy as involving one or more of the following:
Depreciation - This is a tax concept where the property owner pretends that his property is decreasing in value. For residential real estate, it assumes that the property’s improvements will become worthless over 27.5 years. In commercial real estate, the calculation is for 39 years. During each year of property ownership, the owner can take that year’s pro rata depreciation as if it is a loss against the income of the property… which reduces the taxable income of the property, thus reducing the amount of taxes due. Upon future sale of the property, depreciation normally must be “recaptured” which means that there is no more pretending, and the taxes on the truly realized gains must be paid anyways.
Cash out Refi - This is where the owner of the property will refinance the mortgage. The new loan will have a higher balance than the old one, resulting in “cash out”. Because this is just borrowing, it is not a taxable event. Upon future sale of the property, however, taxes will normally be due on the actual gains anyways.
1031 Exchange - Upon the sale of real property, the gains can be deferred if they are used to purchase property of “like kind” within a certain time period. It goes something like this:
- Sell Property A
- Have a “qualified intermediary” receive the proceeds of the sale
- Replacement property (”Property B“) must be identified in writing within 45 days of the sale of Property A
- Property B must be purchased (closed) within 180 days of the sale of Property A
- Property B must be of equal or greater value to Property A
- Both properties must be “like kind”. For instance if Property A was U.S. real estate, Property B must also be U.S. real estate.
So, savvy real estate investors often pride themselves in combining these tax strategies to drastically reduce or even eliminate taxes. This can be a very powerful strategy.
Don’t let the tail wag the dog
Perhaps an even more powerful strategy is to use a Self Directed IRA or 401(k). I think where using retirement accounts can add an advantage is by not requiring you to 1031, refi, or follow any restrictive plan in order to defer or eliminate taxes.
Let’s imagine I buy an investment property in my IRA, and you buy a similar property outside your IRA. We both want to eliminate or defer taxes. I have more options on how I can proceed with my investment than you do.
- When I sell my property, I don’t have to buy another one within a few months.
- I don’t have to continue buying more expensive properties; i.e. “trading up“.
- I don’t have to use a certain amount of leverage to ensure I have enough interest expenses to sufficiently reduce my taxable income.
- I don’t have to borrow my gain through a refinance and bear the interest expense. I can just sell.
- I can focus on maximizing cash flow instead of trying to hit a sweet spot of only getting enough cash flow that can be hidden by depreciation deductions.
- I can invest in real estate options, mortgage notes, revenue participation contracts, and virtually anything else with my proceeds… including assets in a foreign country.
Repeat this situation over and over, and I believe my additional options will sometimes result in better bottom line investment performance. I want maximization of investment performance as my unconditional primary focus, and that is only possible when I can buy what I want when I want.
Simple Advice: Buy & Sell at Different Times
When I had my mortgage company, I asked one of my wealthiest clients why he didn’t use 1031 exchanges. He explained to me, “Jeff, I’m not a genius. I don’t know everything about the real estate market and what it’s going to do. So I have to keep things simple: I buy when property is cheap, and I sell when property is expensive. Normally these two events are further apart than 180 days, so I don’t use the 1031.” He was basically playing on market cycles. Things go up and come down. He buys when they are down, and sells when they are up. I like to take his philosophy a step further: to fully make use of market cycles you must be prepared to invest in real estate in different locations, and in different ways… (i.e. real estate options, debt instruments secured by real estate, different purchase prices, etc.)
In another item of notability, the inflationary situation is creating an encouraging opportunity for investment into any asset not exposed to US Dollars. You can’t use 1031 to defer the gains of a US property into a foreign property.
Imagine how your next real estate investment will go if you knew you could buy and sell when and where you want and still defer the taxes on income and gains.
Feedburner Subscribe
Jeff missed something in this piece. If you buy real estate in your IRA - at the end of the day, when you start taking distributions on your retirement savings you will be paying income tax at a zero cost basis. Buying outside the IRA allows you to satisfy and offset your tax liability as you go. And let’s not forget the added benefit of step up in basis for beneficiaries. And I haven’t even mentioned yet the ultimate intangible benefit of occupancy. Inside the IRA works great for quick turns and bare land. But for those who are considering a longer term investment or would like to use the real estate for themselves or their family, the OUTSIDE™ method is not only financially a better choice, but the only legal choice they have.
Hi, Claire. Thanks for your participation in this commentary.
Buying real estate outside your IRA allows you to attempt to offset your tax liability without being able to enjoy #1, 2, 3, 4, 5, & 6 above. Depreciation and borrowing against equity are short term solutions to long term problems.
When you defer taxes until the point at which you are going to use the money personally, you are maximizing what Albert Einstein said is the 8th wonder of the world - compound interest.
So investing inside an IRA means you are going to defer the taxes until you need/want to spend the money… the maximum tax deferral allows you to pay the taxes later with inflated dollars. Today’s dollar is worth about 4 cents of the dollar in 1913, so playing inflation as a tool for you instead of against you is paramount.
Investing in RE outside the IRA (using IRA money) requires either an immediate distribution of the IRA entirely or a SEPP (substantially equal periodic payment) schedule, based on IRC 72(t)(2)(A)(iv), where you set yourself up to make regular distributions based on an IRS life expectancy table. Either way, the taxation happens earlier. Because of inflation, earlier dollars are worth more than later dollars. So paying earlier taxes often means actually paying more in taxes. And, of course, each distribution (and its related taxes) takes money out of the investment pool that would otherwise be fully compounding interest/returns (you’re not listening to Einstein).
As far as occupancy goes, mixing an investment with personal pleasure muddies the waters of investment decisions. Under your philosophy, you might choose a beautiful property in some place with blue waters even though it has weak cash flow. Then at the end of the day you are thinking about how beautiful the blue water is. Under my philosophy, I’m making predictable, strong cash flow income (100% tax deferred) while making no distributions. While you’re enjoying your blue waters, I’m experiencing superior income at the end of my day. The reality is that you’ve spent your money, while I’ve invested mine…
Often times beautiful properties have income performance inferior to ugly properties. For instance, if you buy a beach front home in San Diego while I buy a small duplex in the midwest, your property will be prettier than mine, but my return on investment will be prettier than yours.
To examine the “get your beautiful retirement home now” argument even further… typically desirable properties (often those near the ocean) have weak cash flow: the price-to-income ratio is less favorable because the buyer/owner is hoping for appreciation.
A failed plan of hoping for appreciation (instead of planning for predictable income) can’t be fixed by any tax strategy. To mix your own personal occupancy with investment encourages the acquisition of pretty properties and hopes for their appreciation. In my book that’s gambling/hoping/speculating. The paying of distribution taxes, income taxes, and gains taxes during the ownership of the property is just the nail on the coffin of the effectiveness of using the “outside IRA method” as an investment strategy.
That said, I think the “outside IRA method” of owning RE (using IRA funds) is a great way for a person to spend their money on their retirement home. The question whose answer will vary in each person’s circumstance is “Are you intending to invest your money or spend it?” If their answer is the latter, the outside method can be wonderful.
I am missing one thing though, and I don’t mean to be facetious (written text has a way of losing its intended tone):
It looks like your company charges up to 4% of the IRA balance to setup the 72(t)(2)(A)(iv) SEPP payments. I can go to my accountant and he’ll setup the SEPP payments for $1000. What am I missing?
For example, if John uses your services for his $100,000 IRA he may pay a fee of up to $4,000. If Frank uses your services for his $900,000 IRA he may pay a fee of up to $36,000. Frank is paying a fee 800% higher than John. Aren’t you simply preparing the same paperwork for both of them? It seems that Frank is paying an 800% penalty for saving and investing more effectively than John. I may be way off, and if so I’d like clarification.
Thanks in advance for your response,
Jeff
p.s. To add to the litany list of discouraging consequences of the “outside IRA method”: property owned outside an IRA usually passes through probate and is subject to the “death tax”, one of the most expensive, most controversial taxes in our country. Assets inside an IRA are passed to beneficiaries outside of probate as a nontaxable event, and the receiving beneficiary can take required minimum distributions based on their life expectancy (the “stretch IRA” concept) which further defers (and reduces through inflation) taxes.