Understanding Tax Deferred Investments: A Guide for Real Estate Investors
Aside from diversifying your portfolio, the ability to take advantage of the tax benefits is one of the main reasons to invest in real estate. However, if you’re not careful, when it comes time to sell your investment property, you can get hit with a pretty hefty tax bill. Fortunately, though, there are ways to invest in real estate while deferring those taxes to a later date. With that in mind, below are the best tax-deferred investment strategies. Read over each one in order to learn which is the best fit for you.
Self-Directed IRA (SDIRA)
Regular IRA vs. SDIRA
As the name suggests, a self-directed IRA allows you to have more control over your Investments. Unlike other IRA accounts, which limit you to investment vehicles that can be traded on the stock market, including stocks, bonds, mutual funds, exchange-traded funds (ETFs), annuities, or Real Estate Investment Trusts (REITs), self-directed IRAs allow for more flexibility. With this type of account, you can also invest in alternative investments like real estate, cryptocurrency, hedge funds, or individual businesses and partnerships.
In particular, with a self-directed IRA, you can invest in real estate assets such as:
- Residential real estate
- Commercial real estate
- Vacant land
- Mortgage notes
- Foreign real estate
- Tax liens
Understanding the tax benefit of an SDIRA
Similar to a regular IRA, you have the option of opening a traditional or a Roth SDIRA. If you choose a traditional SDIRA, you do not pay taxes when you contribute to the account. Instead, you’ll pay taxes when you eventually withdraw the funds. On the other hand, with a Roth SDIRA, you pay taxes on the money you contribute to the fund.
Typically, if your goal is to get the biggest tax benefit, it makes sense to go with a Roth SDIRA. This way, you’re only paying taxes on the amount that you contribute to the fund, rather than the amount you contribute plus any growth that occurs over time. Additionally, a Roth SIDIRA gives you the certainty of knowing what taxes you owe. With a traditional SDIRA, you’ll have no way of knowing the size of the tax bill that you’ll be responsible for in your golden years.
How to use an IRA to purchase real estate
Open and fund an SDIRA
The first step toward investing in real estate with an SDIRA is to open an account. You’ll want to go with a company that specializes in offering SDIRA plans, as these accounts can have potential tax consequences. Notably, most SDIRAs are managed by a custodian, who can help you handle the paperwork and approve your investments. While custodians are not financial advisors, they do serve to help you keep compliant with the appropriate rules and regulations.
Once you open your account, the next step is to find it. In this case, you can either find it directly by making the maximum allowable contribution based on your age or by rolling over a regular IRA account. You can roll over a regular IRA account into a same-kind SDIRA with no tax penalty.
Look for an investment property
Next, you work with a real estate agent to find the right investment property. Once you find that fits your needs and your budget, you’ll make an offer. In order to fund the purchase from your SDIRA, you must list the SDIRA as the buyer of the home and you, typically, must wait to receive authorization of the purchase from your custodian.
If you don’t want to wait for your custodian’s approval, you do have the option of opening what’s known as a “Checkbook SDIRA.” A checkbook SDIRA allows you to make investments without the approval of a custodian. However, having checkbook control means that you are responsible for maintaining the proper paperwork on every transaction and that you are liable for any prohibited transactions.
Fund the purchase
After your offer has been accepted, you will fund your earnest money deposit using money from your SDIRA, not any personal accounts. The money will be held in escrow until you’re ready to close on the home. At that point, your custodian will wire the rest of the funds needed to buy the property and you will add this investment to your property portfolio.
Managing and owning the property
it’s important to note that, in this case, your SDIRA is the owner of the property. Rental payments from your tenants will be made to the account and any expenses must be paid out of the account as well. However, in practical terms, this means that you typically won’t be able to access any of the profit from your investments until you are ready to take distributions in retirement.
Contributions and withdrawals
With an SDIRA, contributions and withdrawals were similar to any other IRA. Currently, if you are under the age of 50, you can contribute $6,000 per year. if you are over the age of 50, you can contribute an extra $1,000 per year. If you are married and filing jointly, those amounts double.
As far as withdrawals are concerned, 59.5 is currently the minimum age for taking penalty-free distributions, if you have a traditional SDIRA and you withdraw money before that time, the amount will likely be subject to a 10% tax penalty. On the other hand, if you have a Roth SDIRA, you can make an early withdrawal under certain circumstances, including buying your first home or using the money for educational expenses.
Once you are over the age of 59.5, provided that your account has been open for at least five years, you can make a withdrawal from a self-directed IRA tax and penalty free. If your account has been opened for less than 5 years, you will still have to pay tax on the amount that you withdraw, but you won’t face a penalty.
Understanding prohibited transactions
Lastly, it’s important to note that some transactions are prohibited under the SDIRA rules and regulations. Namely, transactions that involve disqualified persons. In this case, “disqualified persons” usually include yourself, your spouse, your direct family members like parents or children, or anyone who has advised you in a fiduciary capacity in the past.
Typically, custodians advise that you only use your SDIRA for transactions that are completely arm’s length, which means that all the parties involved operate independently of one another. For example, if you buy an investment property with your SDIRA, rather than doing any renovations yourself, it might be better to contract with a third party company to do the work.
Here, it’s important to understand that engaging in a prohibited transaction could put your whole IRA at risk. if you get caught, the IRS could disallow your entire account, which would force you to withdraw the entire amount and pay penalties on it.
Self-directed solo 401(k)
Solo 401(k)s offer tax deferred options for freelancers or small business owners with no employees. While a self-directed solo 401(k) is similar to an SDIRA in many respects, the biggest difference between the two is the contribution limit. In 2021, the contribution limit is $58,000, with an option to do a $6,500 catch-up contribution if you are over the age of 50.
To understand how the contribution for a solo 401(k) works, it’s important to think of yourself in two separate roles: the employer and the employee. As an employee, you can contribute up to $19,500 in 2021, plus the additional $6,500 catch-up contribution if you are of age. Then, as your own employer, you can make an additional contribution worth up to 25% of your net self-employment income as long as you conform to the total limit of $58,000.
How the tax benefits work
The other nice thing about a solo 401(k) is that you get to pick your own tax advantage. with a traditional solo 401(k) any contributions are made as a pre-tax deferral so they reduce your income for the year that they are made and your distributions are eventually taxed as ordinary income Meanwhile, with a Roth solo 401(k), the money is taxed upfront and your distributions are tax-free.
In general, it’s a good idea to invest in a Roth solo 401(k) if you think that your income will go up in the near future. However, if you think your income will stay the same or go down eventually, it may be worth it to take the tax break now.
How to buy real estate with a self-directed solo 401(k)
For the most part, buying real estate with a solo 401(k) works very similarly to a checkbook SDIRA. With this investment vehicle, you can invest in alternative assets, such as real estate, and you can self-manage the plan, meaning that you don’t need to get approval from a custodian. However, in exchange, that freedom also means that you have to be responsible for maintaining your own records and following the tax rules and regulations.
That said, it’s important to be aware that once your account balance exceeds $250,000, you will need to file a Form 550-SF with the IRS once a year.
Typically, once you’ve funded your account and you have found the right investment property, funding the down payment and purchase price is as easy as writing a check from your account.
The rules around prohibited transactions for a solo 401(k) are similar to those for an SDIRA. On the whole, it’s a good idea to stick to arm’s length transactions and to avoid doing any transactions with disqualified persons.
Health Savings Accounts (HSAs)
Overall, health savings accounts (HSAs) are tax-free investment vehicles available to those who are enrolled in high-deductible health plans. They’re meant to help defray the cost of eligible expenses, such as doctor and dentist visits, prescriptions, and hospital stays. In 2021, the annual contribution limit for an HSA is $3,600 for individuals or $7,200 for families.
Notably, each year, any unused funds will roll over to the next and you do not lose your invested savings if you decide to change your plan later on down the road. Until the age of 65, if you use your savings for a medical expense, any withdrawal is tax free. However, after the age of 65, the money can be withdrawn and used however you, please.
Investing in real estate with an HSA
While it is possible to invest in traditional real estate assets with an HSA, it is generally not recommended. After all, in the event of a medical emergency, it’s best if your Investments are liquid, which real estate is not. However, an alternative investment might be Real Estate Investment Trusts (REITS).
REITS are publicly traded companies that either invest in owning and operating real estate investment or funding real estate transactions. Investors can buy shares of these companies and, in exchange, they receive regular dividends. Yet, they can also sell the shares as needed to cover any expenses.
Doing a 1031 exchange
With all that said, it’s important to note that there is a way to invest in real estate and to defer taxes without using a retirement account. It’s known as a 1031 exchange. With a 1031 exchange, you can defer paying capital gains on the sale of an investment property by swapping it for another, like-kind property.
Since there is no limit on the amount of times that you can do a 1031 exchange, this strategy effectively allows you to avoid paying capital gains taxes until you are ready to leave the real estate sector behind entirely. It essentially means that you get to buy tax-free property until the point.
That said, it’s crucial to realize that there are a lot of moving parts to a 1031 exchange and it is very difficult to stay compliant. For a small fee, there are firms that will act as a qualified intermediary for you and will help to keep you compliant. It’s usually in your best interest to use one of those, as Treasury regulations require that a qualified intermediary be used anyway.
Sheltering income with depreciation
Finally, if you buy real estate outside of a tax-advantaged account, you have the option of writing off depreciation in order to minimize your tax burden. At its core, depreciation allows you to write off a yearly allowance that’s tied to the value of the building. Usually, between depreciation and write-offs, it’s not uncommon for an investment property to be shown as a loss on your tax return.
How depreciation works
Since there’s no way of knowing how long an investment property will be inhabitable, the IRS uses standard depreciation periods. According to them, residential properties have a useful life of 27.5 years while commercial properties have a useful life of 39 years.
In order to find your yearly depreciation allowance, you generally just divide the value of the property by its standard depreciation period. For example, if you bought a $300,000 property, you would have a yearly depreciation allowance of $10,909.
The bottom line
While using deferred compensation to my house can have major tax benefits, the process behind it is usually quite complicated. With that in mind, if you’re going to go this route, it’s important to talk to a tax professional first to make sure you’re on the right track. Once you have their approval, you can move forward with your plan to grow your returns and lower your taxable income as much as possible.