Experienced investors and real estate professionals understand that real estate can be a cornerstone of their retirement accounts. Real estate is an asset that adds diversity to retirement portfolios. Account-holders can find reprieve from stock market volatility by investing their IRAs in rental properties like houses, condos, commercial real estate, townhomes, and duplexes. Retirement investors can use their favorite investment strategies and their IRA funds to purchase rentals, fix-and-flip projects, land speculation, and more.
Once retirement investors reach 59.5 years of age, they can take distributions from their IRAs without incurring a 10% early withdrawal penalty. The time leading up to this milestone is often when investors seize the opportunity to strategize how the real estate will be distributed from their self-directed IRAs.
There are numerous distribution strategies available to IRA real estate investors. The trick is for investors to know and understand which options are available to them, and which choices will best align with their personal retirement goals. You can be the source of knowledge and inspiration for not only your own retirement strategies, but also those in your network who are looking to invest their IRAs into real estate.
The first factor that an IRA real estate investor may take into account for their distribution strategy is their personal income tax rate. If they think they will be at a higher tax rate when they reach the age of distribution, it could be beneficial for the client to invest in real estate with a Roth IRA. Roth contributions are taxed upon going into the account and not taxed upon distribution. On the other hand, if a real estate investor thinks they will be in a lower tax bracket upon distribution age, using a Traditional or SEP IRA to invest in real estate may be the best route, since contributions are taxed upon distribution.
Traditional and Roth* IRAs require account holders to reach 59.5 years of age before taking qualified distributions (distributions without penalty). Because Traditional IRA contributions are made pre-tax, the IRS requires Traditional IRA account holders to begin taking Required Minimum Distributions (RMDs) at 70.5 years of age. Since Roth IRA contributions are made post-tax, there are no RMDs at any age.
*Roth annual contributions may be distributed at any time without tax or penalty. This is not true for the account’s earnings due to the five year rule.
Collect Rent With Tax Advantages
If one of your investment goals is to hold real estate for passive income, you can to continue to rent your IRA’s property and collect rental income. One of the main reasons investors choose IRA real estate is because rental income can go back into the IRA and stay under the tax umbrella. Account-holders don’t have to pay taxes on their rental income until they need it. Therefore, account holders have additional control over their taxable income.
Selling IRA Property
Another option available to account holders is to sell their IRA property. In this case the cash proceeds would go back into the IRA, and can then be taken as a distribution. Traditional IRA account holders will have to pay tax on the cash amount they take as a distribution. With a Roth IRA these proceeds will be tax-free as long as the five-year rule on gains has been satisfied.
IRA holders can distribute the ownership of property “in-kind” by retitling the deed from the IRA to the account holder personally (remember, the initial titling of the property is in the name of the IRA, not the individual.) This process means never losing control of the property, as there is simply a change of ownership.
If the property was purchased with a Roth IRA, account holders can make a qualified distribution of the property without paying taxes on that distribution. If the property was purchased with a pre-tax plan (Traditional, SEP, etc.), the owner will have to pay taxes on the appraisal value of the property upon the time of distribution.
After distribution, account holders are free to use the real estate as a vacation home or a primary residence. Before completing full distribution of the property, the IRS does not allow account holders or any other disqualified persons from residing in or having personal use of the IRA investment property.
If the property was previously held within a pre-tax plan (like a Traditional IRA), it was collecting rent at a tax-deferred rate. Once the property is distributed from the pre-tax plan, and if the owner wants to continue renting the property, the rent will be taxed at the account holder’s personal tax rate. If the property was held in a post-tax plan (a Roth IRA), the account holder will not be able to continue to collect tax-free rent after the property is distributed from the account.
If the self-directed IRA holder uses debt-leverage (i.e. a mortgage) to purchase their IRA’s real estate, they may incur Unrelated Business Income Tax (UBIT) on the debt-leveraged portion of their profits. Once the account holder pays off their IRA’s loan and their debt ratio calculates to zero (by averaging the last twelve months), they will no longer have to pay UBIT on any of their profits.
Avoid Recapturing Depreciation
Depreciation is an appealing tax incentive for real estate investors. Depreciation on real estate looks a little different inside of an IRA verses outside of an IRA. When an investor purchases property outside of an IRA, depreciation is a tax-deferral mechanism in as much as the investor must pay tax on unrecaptured depreciation of the property upon the sale of the home. However, many retirement investors don’t know that your IRA can avoid paying tax on the depreciation that their IRA benefited from in prior years by paying off the loan 12 months prior to the sale. Learn more about that strategy here.
Planning for RMDs
Regarding generational wealth, Required Minimum Distribution (RMD) rules are critical for investors to remember when planning for the future of their investments. If a Traditional IRA account holder doesn’t want to chip away at their account by taking RMDs after they reach age 70.5, they can make a Roth conversion before that time. If they go this route they will have to pay taxes on the conversion amount, so IRA holders will want to consider their current tax rate before converting. Roth account holders can either liquidate or continue to rent or sell their IRA properties tax-free throughout their lifetime, without ever having to take an RMD.
Don’t Rely on Social Security Income
Social factors can play a role in retirement investors’ future planning. Social security has been on a path of decline, pushing many Americans to secure a second source income for their retirement. Real estate investing can be a lucrative resource for IRA holders to secure income for their retirement years.
Self-directed IRA real estate investing has become more popular with each passing year. While real estate is an investment that many account holders are familiar with, knowing and understanding the distribution strategies associated with this asset can help investors make the most of their retirement.
This article is from New Direction IRA - a trusted provider of self-directed IRAs and HSAs.
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