When it comes to purchasing real estate with an IRA, the typical scenario works as follows:
- Roll you traditional IRA into a self-directed IRA
- Identify the investment then contact your self-directed IRA custodian to close on the property
- Going forward all income will flow to your self-directed IRA
Consider Frank, who has $300k in his self-directed IRA and is looking to purchase two rental homes in Houston for $150k each. If the rentals throw off $1,600 monthly rental income, Frank’s numbers might look as follows:
Not a bad return; however, Frank could do better if he understood that his IRAs could use the leverage provided; Frank does not guarantee the loan. This type of financing is referred to as a non-recourse loan, i.e., the lender can only look to the property as collateral in the event of default. Assuming Frank finds a lender, who requires 30 percent down, Frank can use the $300k in his self-directed IRA to acquire six rental homes at $150k each. Now Frank’s numbers will look as follows:
As good as this number looks (an additional $13k a year in income), Frank must face the Unrelated Debt-Financed Income tax, which is a tax that IRAs (and other exempt entities) must pay on income generated from the use of debt financing. Frank’s UDFI tax will be 37 percent of his IRA income. Similar to how you would calculate your income tax on real property owned in your name, IRAs are entitled to the same deductions, i.e., mortgage interest and depreciation. After taking this into account on the six rentals, Frank’s IRA will pay $11,500. Frank’s annual income will look as follows:
Some might think the extra $1,000 annually is not worth the risk of six leveraged rentals over two that are debt-free. This type of thinking misses the larger picture. Look at the numbers 30 years out when your loans are paid off, assuming two percent annual property appreciation:
Using leverage adds $1,000,000 in value to Frank’s retirement, but what if Frank could increase it even further just by changing the entity he uses to purchase the real estate? All it requires is to change how he structures his IRA investments.
The additional $550,000 will come from eliminating the UDFI tax his IRA must pay for leveraging his assets. To eliminate the tax, Frank will shift his investing into a self-directed solo 401k by rolling his IRA into the self-directed 401k. In making this one change, he will earn an additional $13,0000 a year. Here are the numbers again with the solo 401k:
Assumptions aside, this illustrates how using a proper entity structure can help you achieve your financial goals faster.
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