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Ask Millionacres: Tax Implications of Buying Real Estate in a Self-Directed IRA

May 27, 2020 by Matt Frankel, CFP
Q: Almost all of my investable money is in my retirement accounts. How can I assess the tax implications for investing in commercial real estate using a self-directed IRA (SDIRA), either Roth or traditional? -- John H.

A: That's a great question, John. For readers who aren't aware, a self-directed IRA is a type of retirement account that allows you to invest in almost any types of assets you want, as opposed to brokerage IRAs, which limit you to stocks, bonds, and funds. For our purposes, self-directed IRAs allow you to buy properties with your retirement funds.

Now, when you invest in an IRA (either traditional or Roth), there are typically no tax implications while assets are held within the account. With a traditional IRA, any withdrawals from the account are considered to be taxable income, while qualified withdrawals from Roth IRAs are tax-free. And this is generally true for a self-directed IRA as well.

For example, let's say that you open a self-directed IRA by rolling over $100,000 from your current retirement savings. And you use the money to buy a small rental property that produces $600 in monthly rental income after expenses. As long as you leave the money in the SDIRA, you won't owe a penny in taxes. That's even true if you sell the house at a profit.

Where it gets complicated is if you use a mortgage to finance the purchase. It's entirely possible to obtain a mortgage (known as a nonrecourse loan) to purchase real estate within an SDIRA. However, there's a tax provision known as unrelated business taxable income, or UBTI. Without getting too deep into the definition, for SDIRA real estate investors, this essentially means that you can be taxed on the portion of your IRA income that came from borrowed money.

Here's the general idea of how this works. Let's say that instead of using your $100,000 to buy a property in cash, you decide to buy a duplex for $200,000 by putting 40% ($80,000) down and financing the remaining 60% of the purchase with a nonrecourse loan. We'll say that the duplex generates $12,000 in annual rental income, after expenses.

Of this rental income, 40%, or $4,800, would be tax-deferred. The other 60%, or $7,200, would be considered UBTI (specifically, it would be classified as unrelated debt financed income, a subset of UBTI) and would be considered taxable income.

To be sure, it can still be worthwhile to use debt to buy a property in an SDIRA. But be aware that it can complicate your taxes.

One possible workaround is to use a self-directed solo 401k instead, which is an option if you're self-employed. Unlike in a self-directed IRA, UBTI rules don't apply to unrelated debt financed income in solo 401ks, which makes this a much more tax-efficient way to leverage your retirement money to buy real estate if you qualify.

Finally, it's important to note that UBTI can be rather complicated, so it's a smart idea to discuss your particular situation with a tax attorney, CPA, or other experienced professional.

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