Beware of Tax Pitfalls Using a Self-Directed IRA to Hold Rental Property

By: Christopher Ha, Attorney, Certified Financial Planner ®, TCV Law Group

“Papers please.”

German agent – Indiana Jones and the Last Crusade

 

Introduction – Avoiding the Dreaded IRS Demand Letter

 

            Recently our office has gotten several questions concerning using an IRA to hold rental properties.

 

Goal of this blog post:

 

  1. Provide initial framework for deciding whether holding a rental property in an IRA may reduce your income tax bill.

 

  1. Cover common income tax pitfalls we want to avoid so we do not end up getting unwanted audit letters from the IRS!

 

 

Items Not Covered in This Blog Post

 

            The complexity of tax rules governing IRAs rival the complexity of the Labyrinth of Crete. Adding rental properties to an IRA increases complexity by an order of magnitude.

 

We specifically limit this blog post to using a Self-Directed Traditional IRA to own rental property to keep the length of this post manageable.

 

Example of omitted items: some taxpayers may be better served by other entities such as a Solo-401k if they are looking to use debt financing to purchase a rental property inside a retirement vehicle.

 

 

Case Study: How Do Most People Use a Traditional IRA to Save For Retirement?

 

            Example of typical use of an IRA:

 

Mr. Jones, archeologist and part-time professor wants to save for retirement. He uses his Traditional IRA to accomplish this goal as follows:

 

  1. During his working years, Jones makes deposits into his Traditional IRA. Those IRA contributions give Jones a tax deduction during his working years when he is in an elevated tax bracket due to his work wages.

 

  1. Mr. Jones invests the money in this IRA account into traditional stocks, bonds, and mutual funds. His IRA does NOT owe annual income taxes on the interest, dividends, or capital gains earned by the investments in his IRA account. As a result, his IRA account grows without having to pay annual income taxes resulting in a larger IRA balance each year.

 

  1. Ultimately, Mr. Jones retires and starts making withdrawals from his Traditional IRA. His IRA balance is materially larger than a comparable non-IRA account because of the tax benefits described in (a) and (b) above. IRS finally starts to tax the Traditional IRA when Mr. Jones withdraws money from the IRA.

 

  1. Mr. Jones has good tax counsel and spreads out his Traditional IRA withdrawals over many years so that the bulk of his taxable withdrawals occur in years when he is in a low tax bracket.

 

With this IRA strategy Jones has achieved two common goals of tax planning: (a) delay paying taxes as long as possible and (b) when forced to pay taxes, pay taxes while in a low tax bracket.

 

 

Can I Have My IRA Hold a Rental Property Instead of Stocks, Bonds, or Mutual Funds?

 

            Yes. But beware giant tax boulders and snake traps.

 

Due to the complexity of the IRS rules concerning having an IRA own a specific rental property, (e.g., 12345 Blackacre Drive), most IRA custodians will not hold a rental property in the name of an IRA for you.

 

When we use the term “Self-Directed IRA” we use it in the sense that the IRA custodian for your IRA is willing to hold uncommon assets in your IRA such as a specific rental property.

 

In the QA items below we introduce two common tax issues related to owning a rental property inside a Self-Directed IRA below:

 

  1. Prohibited Transactions and
  2. UDFI – Unrelated Debt Financing Income

 

 

Does An IRA Shield Me From Taxes on the Rental Income from My Rental Property?

 

            General rule: yes, rental income earned by a rental property inside a Self-Directed IRA is shielded from annual income taxes.

 

Reason: “passive” income earned inside an IRA such as interest, dividends, and rental income are not subjected to annual income taxes.

 

Exceptions apply. Example: if an IRA custodian buys real estate with the primary intent to flip the real estate in the near term for profit then the rental income is arguably related to an “active business” which causes the income to be classified as UBTI (unrealized business taxable income) which IS subject to annual income taxes.

 

 

Does An IRA Shield Me From Capital Gains When I Sell My Rental Property?

 

            General rule: yes, if an IRA sells a rental property for a capital gain then the capital gain on the sale of the real estate is NOT subject to annual income taxes.

 

Exceptions apply. See QA above.

 

 

Question: Can Holding A Rental Property in an Self-Directed IRA INCREASE My Annual Income Tax?

 

            Some taxpayers may be better off NOT holding a rental property inside a Self-Directed IRA.

 

Sample taxpayer: Marcus.

 

Marcus owns a house that he leases on AirBnb through a property manager.

 

Each year his rental property generates a tax loss after accounting for his rent property deductions such as management fees, repairs, mortgage interest, taxes, and depreciation.

 

Assume Marcus could move that house into a Self-Directed Traditional IRA instead of holding the property in his own name or single-member LLC. (For purposes of this QA, assume the Prohibited Transaction rules described below do not exist.)

 

Would Marcus save money on income taxes by moving the rental property (described above) from his own name into his Self-Directed Traditional IRA?

 

Issue raised – rental income losses. Marcus may qualify as an “active participant” in his rental property and be allowed to deduct up to $25,000 of rental losses against his other sources of income as long as the rental is in his own name (or a single-member LLC).

 

However, if Marcus has his rental property in a Self-Directed IRA, the IRA is a tax-exempt entity that does NOT distribute tax losses to Marcus. Result – the IRA causes Marcus to LOSE deductible tax losses that reduce his annual income tax bill.

 

 

Question: How Can I Ensure That Holding a Rental Property In An IRA Will Reduce My Annual Income Taxes?

 

            You may want to prepare a tax projection for any potential rental property purchases with the help of a trusted CPA or financial advisor.

 

If the rental property is expected to generate taxable losses you may be better off holding the rental property in your individual name (and not in a Self-Directed IRA) so that the tax losses can be used to offset your other sources of taxable income (e.g., wages).

 

If the rental property is expected to generate enough cash flow to show net taxable rental income after accounting for deductions (e.g., mortgage interest, taxes, depreciation) then the rental property may be a good candidate for holding in a Self-Directed IRA so that you do not pay taxes on the rental’s net taxable income.

 

 

Downside Protection – What Can Happen To Me If IRS Finds I Have Not Followed the Rules for Rental Properties and Self Directed IRAs?

 

            The remainder of this blog post covers some of the IRS rules concerning having an IRA own a rental property such as:

 

  1. Prohibited Transactions

 

  1. DFTI – Debt Financed Taxable Income

 

These IRS rules matter because failure to comply with these rules could result in IRS classifying the FULL VALUE of your IRA as being subject to income taxes in the year of failure.

 

The IRS guidance also discusses additional penalties to add insult to injury such as a 10% penalty for early withdrawals from an IRA prior to age 59.5 and a 15% penalty for failing to correct Prohibited Transactions.

 

Example:

 

Donovan causes his Self-Directed IRA to buy a rental property from himself. This is a Prohibited Transaction (26 USC Sec. 4975) because Donovan is on both sides of this transaction.

 

Possible result: the FULL VALUE of Donovan’s IRA is treated as being distributed to him so it is FULLY subject to income tax in year of the prohibited transaction.

 

Say that the value of Donovan’s IRA is $500,000. Adding $500,000 of taxable income to Donovan’s 2022 income tax return is sufficient to catapult Donovan from the 10% tax bracket to the 35% tax bracket.

 

 

Can I Let My Family Use the Rental for Personal Use While Owned by My IRA?

 

            For rental properties owned in an individual’s name (or via a disregarded entity such as a single-member LLC), the owner can typically use the property for a certain number of personal use days (e.g., lesser of 14 days or 10% of days rented out at FMV) without any harmful tax results.

 

In contrast, if Donovan owns a rental property in his Self-Directed IRA then ANY personal use of the rental property by him or his family is a Prohibited Transaction that could cause the full value of the IRA to be subjected to income taxes in the year of personal use.

 

The logic of the Prohibited Transaction rules with IRS is that the IRA is a separate entity from its owner and the owner is not supposed to get any personal benefit of assets inside the IRA entity until the asset is withdrawn and subject to income taxes.

 

The Internal Revenue Manual, Part 4, Examining Process, under Chapter 72, Section 11 for Prohibited Transactions SPECIFICALLY instructs an IRS auditor to check if the IRA owner is making personal use of property in the Self-Directed IRA.

 

 

Do I Need an IRA Custodian to Hold Title to My Real Estate? Why?

 

            Yes. An IRA plan needs to be a separate entity from yourself otherwise you will do not qualify for any of the tax benefits of an IRA.

 

 

Worst Case Scenarios – Can My IRA Custodian Steal From Me?

 

            Potentially yes. The author has heard of cases where a 1031 real estate exchange custodian took real estate proceeds from a client and ran off with the money.

 

Nightmare case: Hindenburg chooses the custodian for his Self-Directed IRA by choosing the lowest bidder.

 

Hindenburg chooses a good rental property and rolls over money from his 401k to his new Self-Directed IRA account so money is available to buy the rental property in the name of the Self-Directed IRA.

 

On the closing day the custodian for the Self-Directed IRA is nowhere to be found and Hindenburg’s money is gone.

 

We strongly recommend vetting the custodian for your Self-Directed IRA. A good custodian can also answer common questions how to administer your Self-Directed IRA and avoid common IRS pitfalls.

 

 

Can I Sell or Transfer a Rental Property I Already Own Into My Self-Directed IRA?

 

            This is a Prohibited Transaction because you are on both sides of the transaction:

 

  1. Seller: you, in your individual capacity.

 

  1. Buyer, you, on behalf of your Self-Directed IRA.

 

            Result: your IRA may lose its tax-exempt status and the full value of the IRA becomes subject to income taxes in the year of the Prohibited Transaction.

 

 

Can My Self-Directed IRA Borrow Money to Purchase Real Estate?

 

            Yes, but there are complications. At least two possible complications below:

 

Complication 1: Harder to Get Financing.

 

Under the prohibited transaction rules for a Self-Directed IRA the taxpayer cannot personally guarantee any loans taken out by his/her Self-Directed IRA because posting collateral or serving as a guarantor for the loan amounts to a contribution to the Self-Directed IRA.

 

Therefore a loan by a Self-Directed IRA to purchase a rental property is limited to non-recourse financing and assets inside the Self-Directed IRA.

 

As a result banks may impose stricter loan terms such as requiring more money down (e.g., 30% down payment) before lending money.

 

Complication 2: Using Borrowed Money Subjects Rental Income to Taxes Even Though the Rental Property Is Inside an IRA.

 

Sample case: Elsa buys a condo for $300,000 for her Self-Directed IRA.

 

Purchase price is funded as follows:

  1. $150,000 of cash in her Self-Directed IRA’s brokerage account
  2. $150,000 non-recourse loan with her IRA as the borrower (assume loan complies with IRS rules)

 

Elas’s condo generates net rental income (after deductions) of $30,000.

 

Half of the $30,000 of net rental income is NOT subject to income taxes under the general rule that rental income in an IRA does not generate income taxes for the IRA owner.

 

Half of the $30,000 of net rental income IS subject to income taxes under the DFTI (Debt Financed Taxable Income) rules because half of the purchase price of condo relates to debt financing.

 

In this case, when Elsa uses debt financing inside her Self-Directed IRA to purchase the rental property, the DFTI causes the income related to that debt financing to become subject to income taxes DESPITE the general rule that rental income inside a Self-Directed IRA is exempt from income taxes.

 

Result to Elsa – using debt financing to purchase real estate inside a Self-Directed IRA may cause her to owe income taxes on rental income even if the rental property is owned inside an IRA.

 

 

Items to Have When Considering a Rental Property In a Self Directed IRA?

 

            “He chose . . . poorly.”

Grail Knight – Indiana Jones and the Last Crusade.

 

Owning a rental property in a Self-Directed IRA could be the Holy Grail of tax-deferred growth . . . or a train car full of snakes depending on your circumstances!

 

For the best chance of success with a Self-Directed IRA and rental property, be sure you have at minimum:

 

  1. Tax projections for the rental to verify it generates enough taxable income to warrant the time and expense of having it in a Self-Directed IRA; and

 

  1. A CPA or tax professional used to working with Self-Directed IRAs and annual income tax forms 5498 (IRA end of year tax value) and 990-T (UBIT and DFTI income); and

 

  1. A competent and completely trustworthy Self-Directed IRA custodian.

 

 

Finally – Don’t Forget to Make Sure Your IRA Coordinates With Your Estate Planning Documents Like Your Will!

 

Be sure to let your estate planning attorneys know about any Self-Directed IRA planning so we can ensure your Self-Directed IRA planning coordinates with your estate plan (e.g., Wills, Trusts, asset-protection LLCs)!

 

Nightmare scenario (one of many): one of your children is going through a divorce so you have updated your Will so the inheritance is shielded from marital property claims.

 

HOWEVER, the beneficiary designation on your Self-Directed IRA did NOT get updated and the inheritance that passes outright to your child and becomes community property via commingling and becomes SUBJECT TO SEIZURE by the soon-to-be ex-spouse of your child.

 

            We hope this has been helpful.