Many people choose to invest in real estate so they can benefit from the tax advantages and also diversify their portfolio. While there are a number of tax incentives that can be used during the time you own a piece of real estate, when it eventually comes time to sell, you can be hit with some lofty taxes.
However, there are ways to invest in real estate without paying any tax on the gains you make -- or to possibly defer taxes to a later date. These strategies are available to almost anyone and can save tens of thousands, or hundreds of thousands of dollars in taxes each year.
It's important to note that many of these tactics, such as investing in a self-directed IRA, Solo 401(k), or HSA, are long term strategies. You can invest in real estate with these vehicles tax-deferred or tax-free, but you will need to wait until retirement to withdraw the funds to avoid penalties. Let’s explore what these options are and how each of them works.
Self-directed IRA (SDIRA)
An individual retirement arrangement (IRA) first became available as a part of the Employment Retirement Income Security Act of 1974. It was intended to encourage individuals to build a more stable financial future and retirement fund by growing money tax-free in a Roth IRA or tax-deferred in a traditional IRA.
What investments do IRAs cover?
IRAs are limited to traditional investments that are traded on or related to the stock market. These include stocks, bonds, mutual funds, annuities, exchange-traded funds (ETFs), and real estate investment trusts (REITs) … really anything traded on the stock market. They do not include alternative investments like real estate, businesses like partnerships or LLCs, precious metals such as gold or silver, cryptocurrency, hedge funds, and oil and gas, among other assets. That is unless you have a self-directed IRA (SDIRA).
What's a SDIRA?
A SDIRA is similar to a normal IRA but allows you to invest in alternative asset classes such as real estate. With a self-directed IRA, you can invest in real estate assets such as:
- Residential property (one- to four-family homes, condominiums, and townhomes) as a rental or flip
- Multi-family housing
- Commercial property
- Mortgage notes
- Foreign real estate
- Vacant land
- Farms or ranches
- Tax liens and tax deeds
You can elect to have a Roth self-directed IRA which means you pay taxes when you contribute money to your IRA rather than when you withdraw it. This means your cash will grow tax-free. The other option is a traditional SDIRA, which defers your taxes. In a traditional SDIRA, you do not pay taxes when you contribute, but instead pay taxes when you make a withdrawal.
Out of the two, a Roth SDIRA offers the best tax advantages because you pay taxes on a smaller amount of money at the point when you invest it. I personally would much rather pay taxes on $6,000 now than pay taxes on $15,000, $25,000 or more in my retirement years. Not to mention that the chances of our tax rates decreasing are pretty minimal -- it’s much more likely that they will increase in the future. Ultimately you never know what you may have to pay 10, 20, 30, or 40 years from now, so why not pay taxes on less money now?
Let’s give you an example of how this could work:
- You find an off-market duplex for sale and purchase it with your Roth SDIRA for $195,000.
- You keep the rental for 20 years, receiving an average of $1,400 per month in net cash flow which equates to $336,000 in net rental income collected over the 20 years. For simplicity I’m not accounting for rental increases, vacancies, or ongoing maintenance costs. Since your Roth IRA owns this investment, all that rental income is paid directly to your SDIRA and is completely tax free.
- You then decide to sell the property for $375,000. $375,000 for the sale plus $336,000 in rental income comes to $711,000.
- That means you have made on $516,000 your initial $195,000 investment, completely tax-free!
If you conducted this same transaction in a traditional SDIRA, you would end up paying tax on the $516,000 instead of the $195,000. See why paying taxes on less is typically better?
Contributions and withdrawals
Currently, if you are under the age of 50, you can contribute up to $6,000 per year into an IRA and an additional $1,000 if you are 50 or older. The April after you turn 70 and a half, there are required minimum distributions (RMDs) -- amounts that you must withdraw -- that are mandated by law. If you want to see how much your RMD would be based on your investment account and age, you can use an online retirement calculator to get a rough idea. There also are certain thresholds that may limit how much you are able to contribute to your SDIRA, or even disqualify you from having one to begin with.
SDIRA participants can withdraw funds at any time after the age of 59 1/2 without penalty. Any withdrawals before that may be subject to a 10% penalty. If it is a traditional SDIRA, each year the total distribution made from the account is taxed as regular income. If it is a Roth SDIRA, as long as the account has been open at least five years and your withdrawals don’t exceed your earnings, you are able to take withdrawals before 59 1/2 in certain circumstances.
Opening a SDIRA
There are a number of IRA companies that specifically offer SDIRA plans such as the Entrust Group, NuView Trust, Quest Trust Company, or American IRA. It’s important to find out what their annual fees are, whether there are any fees for creating a new account, and what their process is like for funding an investment. Some move more slowly than others so ask around for client feedback and speak to other SDIRA account holders about who they use and why.
You can either start a new account and start making the maximum annual contributions based on your age and income or, if you already have an established IRA, you can rollover your current account into a same-kind SDIRA without any tax penalties. That means a Roth IRA would become a Roth SDIRA and traditional IRA could become a traditional SDIRA.
Self-directed IRA companies will have a custodian to assist you with the required paperwork and approval of each investment within your IRA. Custodians are not financial advisors and do not give advice on which assets to invest in or not invest in, but instead keep you compliant with SDIRA rules and regulations. You can also choose a plan that offers checkbook control, in which you bypass the required approval of a custodian.
While most SDIRA companies do their best to review and authorize each transaction as quickly as possible, it’s not uncommon for funding to take several days or weeks. Many people prefer having checkbook control because transactions are processed at a much faster rate and often cost less because there are fewer people involved in the transactions. However, having checkbook control means you are liable for any prohibited transactions and are responsible for maintaining proper records of every investment and transaction. It’s up to the individual to see which option best fits their needs.
There are certain restrictions called prohibited transactions that must be avoided if you are investing with a SDIRA. If the investment directly transacts with a disqualified person, it would be considered prohibited and should not be done with your SDIRA.
A disqualified person is:
- Your spouse
- Your lineal descendants (children or grandchildren)
- Your lineal ascendants (parents or grandparents)
- A financial or legal professional who advises you in a fiduciary capacity
- Any business entity that any of these individuals’ control
This includes lending money to them, buying an asset with them or for them, or using your SDIRA funds to work with them in any capacity. So, you can invest in a real estate venture with your sister, brother, cousin, or niece, but not your parents, daughter, or son. You could buy a rental investment and rent it to your brother or sister, but you couldn’t rent it to your daughter, granddaughter, or father.
Your SDIRA would also not be able to "buy" an investment you already own or have an interest in because you are directly tied to the transaction. Most custodians advise only investing in opportunities that are considered arm’s-length transactions, meaning your direct interaction with the investment is minimal (you don’t renovate the home yourself but hire a third-party company to do the renovation).
It’s also very important that your SDIRA is responsible for paying all costs associated with the transaction. You do not want to pay a utility bill, buy materials from a hardware store, or pay for any other costs associated with the property from your own personal or business account and have your IRA repay you. This could potentially be construed as self-dealing since you, a disqualified person, are paying for things associated with the transaction.
Participating in a transaction with a disqualified person or not following the guidelines for SDIRA puts your whole IRA in jeopardy. If caught, the IRS could potentially disallow your entire IRA, meaning you have to make a withdrawal of the entire amount while paying fees and penalties, and losing out on any tax advantages you once had.
Having a SDIRA can allow you to gain higher-than-average returns that are secured by alternative asset classes. Instead of being limited to the volatility of the stock market, you can diversify your portfolio and find opportunities that offer a higher return on investment. This avenue of tax-deferral or tax-free retirement growth is still a relatively new concept, but it’s an investment vehicle that should not be overlooked. There are far more positives than negatives in having a self-directed IRA, especially if your goal is to invest in real estate.
Self-directed solo 401(k)
A self-directed solo 401(k) is a great alternative retirement plan for real estate professionals or small business owners who are self-employed with no employees. The largest benefit of a solo 401(k) compared to an SDIRA is the contribution amount. As of 2019 you can make a personal contribution up to $19,000 per year if you are under 50, and $25,000 per year if you are over 50.
But because this is a business plan, the business can contribute a profit share of up to 25% of your company’s net earnings with a maximum combined contribution equal to $56,000, or $62,000 if you are over the age of 50.
However, having no employees is key, as a 401(k) plan has to be available to all qualified employees. If you have multiple employees, you’d no longer be eligible for a one-participant plan. If you have employees or plan on having employees at your business in the future, a normal, non-solo 401(k) plan may be a better option.
How it works
With a solo 401(k), you are able to actively purchase alternative assets, such as real estate, and self-manage the plan, meaning it requires no custodial approval. You are required to maintain the proper records and there are additional records and forms that need to be kept as a part of having a solo 401(k). Checkbook control means that you can allocate your investment funds as quickly as needed by wire or check, which can make or break a deal in some investment opportunities. Eventually, if your account exceeds $250,000 in assets, you will need to file a Form 5500-SF with the IRS once a year.
Traditional solo 401(k) plans are a tax-deferral strategy where you are taxed when you withdraw your funds. While you can convert your solo 401(k) into a Roth solo 401(k) with some firms (and so pay taxes when you pay in your money), most people prefer to structure solo 401(k) plans in the traditional sense (and pay taxes when they pull their money out). This is because by making these large contributions, they can significantly lower their tax brackets.
The rules and regulations of an SDIRA are more or less the same as with a self-directed solo 401(k). You should avoid purchasing transactions that you are actively involved in or engaging in a transaction with a disqualified person.
Solo 401(k) loan
An added benefit that almost no other retirement plan can offer, is the ability to personally borrow as much as $50,000 or up to 50% of the account, whichever is less, for a maximum of a five-year term. This is not an option with a SEP IRA nor a self-directed IRA.
This loan can be used for personal financial needs, such as purchasing a car. And if the loan will assist in purchasing a personal primary residence, the loan period can be extended up to 15 years. A note should be created between your solo 401(k) plan and yourself outlining the interest rate (which must be considered reasonable relative to fair market rates), term, and payment amount.
Maximize your contributions
The big advantage of these plans is that you can save a lot of money quickly and lower your current tax bracket. It would take over nine years of contributing $6,000 to a traditional self-directed IRA to be able to match the annual contribution of $56,000 with a solo 401(k).
If you take that $56,000 you contributed in just one year and bought a real estate investment, such as a mortgage note that produced an annualized yield of 8%, in that same nine-year period you would have turned the $56,000 into $111,944 without making any additional contributions. While you will eventually pay taxes on the $111,944 it will be done through annual distributions which is only a portion of your account and taxed as regular income. Like a SDIRA you can withdraw funds without penalty any time after 59 1/2.
You will need to create a solo 401(k) through an approved firm. Typically, companies that offer self-directed IRA plans have options for this as well. If you have a business that produces a considerable amount of annual income, this is not only one of the best ways to make tax-deferred real estate investments, it is honestly one of the best plans available today.
The sheer fact of being able to maximize your contributions while lowering your tax bracket means you can achieve financial freedom through real estate at an accelerated rate.
Health savings account (HSA)
A health savings account is a tax-deductible savings plan available to those enrolled in a high-deductible health plan (HDHP). It is intended to assist in paying for any medical expenses such as doctor visits, dental exams, eye care, prescriptions, or hospital expenses. As of 2019, you can contribute up to $3,500 for a personal HDHP plan, or up to $7,000 for a family HDHP from your pre-tax income, meaning you do not pay taxes on your contribution.
While HSA plans do allow alternative asset investments like real estate, it is important to note that investing in traditional real estate may not be the best option for this plan. Most people use their HSA to save for significant unexpected medical expenses. Having your HSA tied up in rather illiquid investments like a single-family rental can be a problem in the event of a medical emergency. Investing in a real estate investment trust (REIT) may be a better option for your HSA. REITs are typically traded on the stock market, paying a dividend return to their investors. These are much more liquid than traditional real estate and can be a better alternative, still secured by real estate. While this can be an excellent way to invest in real estate tax-free, it may not be the best choice for everyone.
Each year, your unused funds roll over to the next year and you do not lose your invested savings if you change plans. If you use the HSA funds for a qualified medical expense, the withdrawal is tax free. At age 65, you can withdraw the savings from the account without any tax penalty and use it as you please.
If you made the maximum contribution of $3,500 for 15 years and received a 6% average return, you could end up with $74,000 completely tax-free, depending on your tax bracket and domicile state.
This is another incredible tax-free alternative that lets you grow your money while having the freedom to invest in real estate. Many people add this plan to their retirement portfolio around middle age as they prepare for potential rising medical expenses in their later years while having the financial ability to pay for small and reoccurring medical expenses now. Similar to a solo 401(k), you can open an HSA account at most self-directed IRA companies, although there are companies made specifically for HSA accounts.
A 1031 exchange allows you to invest in real estate and defer taxes when you sell the property, even without using a savings or retirement account like a self-directed IRA, HSA, or solo 401(k). This is a tax-deferred exchange that allows you to transfer an investment property you currently own for a like-kind property without having to pay capital gains. If used properly, and if your property qualifies by passing a usage test under paragraph 280 of the tax code, this is one of the best tax strategies available to real estate investors.
There are specific companies that specialize in conducting 1031 exchanges that will provide you with a qualified intermediary (QI) who acts as the buyer and seller on your behalf during the exchange. Treasury Regulation §1031.1031(k)-1(g)(4)(iii) requires that a qualified intermediary is used during the exchange. They charge a small fee and help keep you compliant with IRS as well in adherence with the several several requirements and rules that must be followed, including a strict time frame in which the exchange must happen.
After the seller receives a signed contract for the sale of the property they want to exchange, they have a 45-day identification period in which they must find and identify up to three like-kind properties regardless of fair market value, or as many properties as they would like so long as they don’t exceed 200% of the property value of the asset being sold. After the original property is sold, there is a 180-day window to close on the newly identified asset. The money from the exchange is held in an escrow account, and it’s incredibly important the seller never touches the funds, as this would disqualify the exchange and the seller would be subject to taxation on the funds.
Let’s say you bought an existing storage facility for $350,000, putting $50,000 down and mortgaging the remaining $300,000. The property needed a lot of work and after increasing rents and making capital improvements, the property is worth $700,000 two years later. If you decided to sell this in a traditional sale, you would be subject to a capital gains tax, which can vary from 15% - 20% depending on your tax bracket, a depreciation recapture tax rate of 25%, and possibly a state tax depending on your state of residency.
After closing costs, commissions, and paying off the remaining mortgage, you would net around $350,000 and would have to pay around $70,000 in taxes if you were taxed at 20%.
Instead, you decide to do a 1031 exchange to capture the $350,000 in equity and you exchange the storage facility property for an apartment complex valued at $900,000. You use the $350,000 as a downpayment and get a mortgage for the remaining amount. You have now turned your $50,000 initial investment into a $350,000 investment without having to pay taxes on the gain.
There are no limits to how many times you can do a 1031 exchange, so ultimately you could continuously defer those taxes until death.
Use one strategy or all of them
One of the beautiful aspects of the tax-deferred or tax-free strategies discussed above is that there are no limits to the number you can use. There are no regulations stating you can’t participate in a self-directed IRA while also having an HSA. I personally have a solo 401(k) and plan on doing 1031 exchanges in the future.
It's really a matter of finding the best fit for your retirement and investing goals in order to invest in real estate in the best way possible for you. It’s important to continue to learn more about each option or consult a specialist in these areas. They can further guide you on which strategy is the right one to implement as a part of your retirement and real estate portfolio plan.