Investing in real estate with your IRA is an option for diversifying your portfolio and increasing revenue potential, but you lose access to certain strategies and tax advantages when you do that. For example, those investing in real estate may be hesitant to leverage their IRA since that means sacrificing depreciation and the tax benefits it comes with.
John Bowens, Director, Head of Education and Investor Success, sat down with BiggerPockets Money podcast hosts Mindy Jensen and Scott Trench to discuss the pros and cons of each strategy.
Property depreciation outside of an IRA
When you invest in real estate outside of your IRA, you’re likely able to deduct depreciation from your taxes, reducing your taxable income and saving you money. The IRA allows depreciation to account for things like deterioration or obsolescence of the property.
Some investors divide the cost or value of the property by its approximate life span (typically 27.5 years) to determine annual depreciation, while others conduct a cost segregation study for a more in-depth view.
However, upon selling the property, you could be able to recapture that depreciation, which may result in a substantial capital gains tax unless you employ specific strategies such as a 1031 exchange, which only defers it rather than eliminates it.
Benefits of investing in real estate with an IRA
While you might not be able to claim depreciation and reduce your taxable income, investing in real estate with a self-directed IRA has multiple tax advantages as well.
An IRA is an inherently tax-exempt environment. Much like stocks, bonds, and mutual funds, the capital gains you earn from a real estate investment can compound tax-free while it is in your IRA.
Your tax strategy can also differ depending on the type of account you in invest with. If your investments are held in a Traditional IRA, then you pay taxes once you withdraw funds. However, if your investments are held in a Roth IRA, then you pay taxes on funds before you deposit them and can complete qualified withdrawals tax-free once you reach retirement age.
When UBIT comes into play
Another concern that investors may have when it comes to holding real estate with their IRA is UBIT, or unrelated business income tax. This tax only applies when an investor purchases a property in their IRA with debt, such as a non-recourse loan, and even then, only a portion of the profit is eligible for the tax.
UBIT only comes into focus for the amount of profit that came from the debt-financed portion of the purchase. For example, an investor purchases a $200,000 property, partially with money from their IRA and partially from funds coming from a $100,000 non-recourse loan. That year, the investor nets a $20,000 profit, minus all costs associated with the property. Because only 50% of the property was financed by debt, only 50% of the $20,000 profit is subject to UBIT.
That $10,000 would be subject to a 20% tax, as John explains, not the often-cited 37% tax rate.
More to consider
As John and the hosts point out in this episode, there is often more to consider than just whether you should invest in real estate with or without your IRA, though that’s an important step.
- Private lending: Rather than investing in real estate directly with their IRA, some investors choose to lend money against real estate and have the interest flow into their IRA tax-free.
- UBIT exemptions: There are cases where you may be exempt from UBIT taxes, like with certain scenarios with a Solo 401(k). However, Solo 401(k)s are only available if you are self-employed or a business owner with no full-time employees, so this strategy would not work for all investors.
- Financing: The ways an investor finances a property can vary depending on if the transaction happens inside or outside the IRA.
- Prohibited transactions: The IRS has rules regarding how investments inside your IRA are handled. For example, you can’t rent a property held in your IRA to your spouse or children, nor can you do physical work on your property.
What’s best for you
A benefit of real estate investing communities like BiggerPockets is the resources they provide to investors that help them determine the best route, like the Money Podcast. There is no single solution that will work for every investment, so those looking to get in the market should speak to tax professionals and carefully examine the advantages and disadvantages of each option before making a decision.
Learn more about different strategies for real estate investing and hear specific investor examples – watch this episode of the BiggerPockets Money podcast.
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