Jeff Nabers’ Self Directed IRA & Solo 401(k) Blog

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 (more…)

I recently talked to a real estate investor friend online who I have known for about 4 years. He started investing in the height of the housing bubble, and now I think he’s finding it difficult to shed the “bubble mentality”. In our conversation I did my best to cause him to question his perspective and his investing strategy.

I’ve pasted our Instant Message conversation below (with the screen names changed for privacy). I didn’t correct capitalization, punctuation or spelling errors, so you’ve been forewarned.

I thought this would be a useful post because of how tightly this gentleman seemed to grip onto his investment strategy he’d been using since 2004. How tightly are you gripping onto your investment strategy?

[19:00] re_investor: HI Jeff
[19:00] re_investor: How are you buddy?
[19:00] jeff_nabers: Hey there
[19:01] jeff_nabers: I’m doing good. How are you?
[19:01] re_investor: How have you been doing?
[19:01] re_investor: Im alright!
[19:01] jeff_nabers: How’s the RE market up there?
[19:01] re_investor: OH its tight!!
[19:01] re_investor: Its flat and declined over the pervious 6 months
[19:01] re_investor: TOUGH
[19:02] jeff_nabers: what about cash flow?
[19:02] re_investor: Its cashing …
[19:02] re_investor: but, its still tight. I actually was in the process of buying another one
[19:02] re_investor: I stoped canceled the purchase/sale
[19:03] jeff_nabers: how did your previous investments turn out?
[19:03] re_investor: Oh great actually..
[19:03] re_investor: I sold the one in Fairview park
[19:03] re_investor: I got a cash buyer
[19:03] re_investor: The other three are turning out fine
[19:04] re_investor: The one house I have I have 67K in equity right now
[19:04] re_investor: I am currently renting it for 1K
[19:04] re_investor: but, I cant do anything with it until the maket comes back
[19:04] jeff_nabers: Sounds decent
[19:04] jeff_nabers: how’s the cash flow return?
[19:04] re_investor: Its about 300 dollars
[19:04] jeff_nabers: renting it at $1k what do you net per year?
[19:04] jeff_nabers: i see so 6k per year
[19:05] jeff_nabers: how much money did you put into it?
[19:05] re_investor: I was just in the process of refinancing it
[19:05] re_investor: and the mtg company I was using closed up
[19:05] re_investor: so the refi stoped
[19:05] jeff_nabers: how much money did you put in tha tone?
[19:06] re_investor: I was bummed out
[19:06] re_investor: I put in 15K
[19:06] re_investor: to fix it up
[19:06] jeff_nabers: and the down payment was?
[19:06] re_investor: It was alot
[19:06] re_investor: I cant remember…
[19:07] re_investor: I am trying to do something with the equity.. but, I dont know what
[19:07] re_investor: There is not much I can do
[19:07] jeff_nabers: you don’t remember how much you put down?
[19:08] re_investor: why are you wanting to no such details?
[19:08] jeff_nabers: i’m curious what your return is
[19:08] jeff_nabers: cashing out would only decrease your cashflow
[19:08] re_investor: I got into it on no money down
[19:08] re_investor: I had good credit
[19:08] jeff_nabers: well then i would never refi it and never sell it
[19:09] jeff_nabers: you are making a 40% annualized return on the cash you put in
[19:09] re_investor: yeah. Its only worth so much you know
[19:09] jeff_nabers: why would you ever want to take an asset like that off your books?
[19:09] re_investor: To use the equity in the house
[19:09] jeff_nabers: with 10 - 15 of those you’d never have to work again
[19:09] jeff_nabers: to use the equity to do what? continue working real estate like a job?
[19:10] re_investor: right. I just need 9 - 14 more of them
[19:10] jeff_nabers: do your other properties cash flow like this one? (more…)

The most notable difference between endeavors down the path of using a self directed IRA versus traditional investing is the unique rules that apply to the former. The extremely simple rule is that an IRA (specifically) cannot buy life insurance or collectibles (such as rugs, works of art, alcohol, bullion).

The more involved rule is known as “no self dealing” and is described in Internal Revenue Code section 4975. This rule basically says that for each retirement plan/account, there is a list of “disqualified persons” with whom that plan cannot do business. These DQPs include:

1. The accountholder/participant and any other fiduciary (person who makes investment decisions for the plan)
2. Companies who provide services
3. A member of the family of #1 or #2 above (family defined as spouse [husband/wife], ancestor [parents, grandparents, etc], lineal descendants [children, grandchildren, etc], and spouses of lineal descents)
4. A corporation (or other entity) that is 50% or more owned (directly or indirectly) by #1, #2, or #3 above
5. An officer, director, 10% or more owner, or highly compensated employee of #4 above.
6. A 10% or more (in capital of profits) partner or joint venturer of #4 above

Every self directed IRA/401(k) investor should make this DQP list before making any investments.

Too many people seem to think of the list as only “the accountholder and his family”. As you can see it is a bit more involved than that. This doesn’t require calculus, but you should actually write out the list step by step to ensure that it is complete. This list can actually get quite extensive if you, your family member, or anyone who provides services to your plan has ownership in several companies.

So, what is a prohibited transaction?

In a nutshell, when a DQP transacts with a plan it is a prohibited transaction (abbr “PT”). The trick here is what is considered to be a “transaction”. This is generally defined in IRC 4975 as when one of the following happens between a plan and DQP directly or indirectly:

• sale, exchange or lease of property
• lending of money or extension of credit
• furnishing of goods, services, or facilities

So I consider that to be the general rule. There are a couple of special rules and they (more…)