If you have an IRA chances are you have heard from someone, somewhere along the way that you can, and that you should, invest in real estate inside your IRA.
The truth is that you can invest in physical real estate inside your IRA (as long as it's not a property you live in), but should you?
There are several things to know and consider if you are thinking about investing in real estate inside your IRA, and after taking into consideration all the various factors and stipulations regarding real estate investing in your IRA it becomes pretty clear that it is not very advantageous to invest in real estate inside an IRA.
Let's dive in.
Why invest in real estate at all?
Real estate investing can offer appreciation on the property itself (property can go up in value), it can offer income and cash flow from rental income and real estate investing offers attractive tax benefits.
Some of the tax benefits include being able to deduct certain expenses related to the property (like new water heater, new flooring, new paint job) against the rental income that the property generates. This is nice because it will lower the taxable income that the property produces.
Another nice tax benefit is the ability to depreciate the property. Depreciation is simply spreading the cost of the property over it's useful life. A nice benefit with depreciation is that it is deductible against the rental income as well, and likely is one of the biggest yearly deductions the property has which reduces the taxable income from the property.
One other nice tax benefit of real estate, is that the income you receive form a rental is not subject to any self-employment tax. Self-employment tax is a tax of 15.3% on certain self-employed business income. But rental real estate income is not subject to this tax.
So why not invest in real estate inside my IRA?
The main reason not to invest in real estate inside your IRA is due to one thing...taxes.
Some of the biggest benefits from real estate are tax related and when you invest in real estate inside your IRA, you literally lose most of those benefits.
Here's why.
An IRA is a tax-deferred account. Any investment inside the account grows in value and may produce income, but you pay no tax on the growth of your investment or the income your investment produces while it is inside your IRA. You pay taxes when you withdrawal from the IRA; and you pay ordinary income tax rates on the withdrawal.
And the IRA tax treatment trumps any tax treatment of the investments inside the IRA. This means that it doesn't matter how a particular investment or strategy is normally taxed, if it's inside the IRA it is subject to the ordinary income tax treatment on any withdrawals from the IRA.
For example, let's say you have a piece of rental real estate that you've held for more than 1. Let's also say that the property has gone up in value from $100k to $200k. You're now looking to sell that property outright and not do a 1031 exchange. You're looking at a taxable long-term capital gain on the $100k appreciation on the property, and depending on your income that $100k long-term capital gain will be taxed at either 0%, 15% or 20%. These are typically more favorable rates than ordinary income rates.
But if you have that property inside your IRA you will not get capital gains tax rates on the $100k gain on the property when you sell it. Instead, the gain will be tax-deferred inside the IRA and then when you go to withdrawal that gain from the IRA you will be subject to ordinary income tax rates on that gain. And if you want to withdrawal the gain before age 59 1/2 you also get hit with a 10% additional tax for an early withdrawal.
You've likely created a bigger tax bill for yourself on this particular transaction by having the real estate inside your IRA.
Another tax benefit you loose is the ability to deduct expenses paid against the income a rental property generates.
Because of the ability to deduct expenses, including depreciation, against the income that a rental property generates you likely don't pay much, if any, income tax on the rental income in the early years of owning the rental property.
However, if you own the rental property in your IRA you lose the ability to deduct any expenses against the income that the property generates. You essentially turn all the rental income from low to no-tax income in the early years of the rental property, to ordinary income taxed at ordinary income rates. This is because the rental income received needs to stay in the IRA and then if you want to use the income you need to withdrawal the income from your IRA. And remember, any withdrawals from your IRA are taxed as ordinary income.
Another lost tax benefit of holding your physical real estate in your IRA is the step-up in basis benefit.
When you die, whoever inherits your property will receive a step-up in basis.
This is huge because if the beneficiary of your property wants to sell the property after inheriting it, they can sell it with a stepped-up basis which will significantly reduce any capital gains tax due.
For example, let's say you bought a rental for $100k. $100k is your basis. If your property grew in value to $200k and you sold it you would owe capital gains tax on the growth of $100k ($200k value-$100k basis=$100k gain).
However, if you pass on the property to your child when you die. Your child gets a step-up in basis to the market value on the day you die. So if the home was worth $200k on the day you die, $200k is your child's basis in the property. Your child could then go ahead and sell the property for little to no taxable gain.
Not too bad.
But if the property is in your IRA, then you don't get a step-up in basis.
Why?
Because, again, everything in the IRA is taxed as ordinary income when it is withdrawn.
In the previous example, if you died and your child inherited your IRA with your rental in it, your child could sell the property for $200k and then withdraw the proceeds from your IRA but they would pay ordinary income tax on $200k when the funds are withdrawn from the IRA.
One last thing to be aware of is paying for repairs and maintenance on the property.
When your property is in your IRA, you need to pay for all of the expenses and repairs on the property from your IRA.
If you need a new roof, you can't just pay for the new roof out of your checking account. You will need to have ample cash in the IRA to pay for the new roof.
And since IRA contributions every year are relatively low, $7k if you're under age 50 at the time of this writing, it may be difficult to have ample cash on hand for the inevitable repairs that come with owning a property.
Bottom Line
There are a lot of real estate "gurus" out there that will tell you to invest in real estate in your IRA.
While it can sound interesting and enticing, you really need to think about the tax implications when it comes to doing so. When you analyze the tax implications, I think it's apparent that physical real estate is not really an ideal asset to hold inside your IRA.