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By: Quincy Long
Normally, gains on real estate purchases and subsequent sales are taxed if there is a profit at some point. Most people know that you can buy and sell real estate in IRAs and Individual(k) Plans, and this goes for Roth IRAs is well. Roth IRA s are the key to tax free income.
When you purchase a fixer in an IRA or Employer Sponsored Qualified Retirement Plan like an Individual(k) Plan or Profit Sharing Plan (the "Plan"), the funds to make the appropriate repairs and modifications must come from the Plan. Any payment from outside the plan would disqualify the transaction. You could leverage the transaction, but the leveraged portion would be subject to unrelated business income tax, or UBI if the profit exceeds $1,000 for all such transactions in a plan. In and of itself, UBI is not a disadvantage as the proceeds after tax still go into a tax-free or tax deferred plan. You could partner with others, and even yourself under certain circumstances.
Another method is the option.
The option for a property often provides some consideration to purchase a property at a given price at a given time in the future. The original owner retains the ownership until the option is exercised. Once you have located the property you wish your IRA to own, you have an independent third party to complete the option contract and agree with that third party to purchase the option contract from him or her at an agreed on price. On completion of the work on the property, you purchase the option contract with your Roth IRA funds from the third party. The third party makes an appropriate profit, of course. You have, during the interim, located a purchaser for the property. You direct your Roth IRA to exercise the option agreement with the original seller and subsequently sell to your buyer. The profit goes into your Roth and the transaction results in a tax-free gain.
Generally IRAs have to buy assets with something other than no consideration, so money has to go into the deal. In this deal, the obvious issue is that you are putting money into a fixer where the optionee can potentially benefit from improvements and you have nothing, not to speak of the independent third party. This means that you need to make sure that the option is properly constructed so that the improvements you make are properly tied up as part of the option agreement.
This real estate option transaction can be completed in your qualified plan, such as an Individual(k), profit sharing, or money purchase pension, or even an IRA Based plan such as a SEP-IRA, SIMPLE, or Coverdell Educational Savings Account. This is significant as you may be in a position to convert many of these accounts to a Roth. You should convert if you are eligible (making less that $100,000 in the year of conversion, singly or married). Conversions should also consider your age and tax rate in the year of conversion, also Coverdell Education Savings Accounts may not be converted. There are few times in most cases when conversions don't make sense.
Conversions from Qualified Plans require that you are permitted take a distribution from the plan and rollover to a traditional IRA , and then convert.
The Coverdell Educational Savings Account is a great place in which to do this transaction, as it can take small $2,000 contribution and build it very quickly to many tens of thousands. One example is of a person (student) who is the beneficiary of one $2,000 Coverdell Educational Savings Account, (the $2,000 contribution was made the last day eligible (the day before age 18)) and at the end of one year had in excess of $125,000 just by rehabbing properties. The $125,000 continues to be invested, and the student takes tax-free distributions for education purposes, until age 30. This in effect means that the student has 12 years to generate significant tax-free income. 30 days after the student turns 30, the remainder of the Coverdell Educational Savings Account must be distributed to the student, and tax is paid at the ordinary income tax rate of the student at that time.
Also, during this time from age 18 to 30, if the student has earned income up to current income limit, the student may contribute $4,000 per year, this is also tax-free money earning tax-free income.
The number of possibilities is significant, and doing options is just one way to increase your, and your children's, or grandchildren's wealth.
Entrust Retirement Services, Inc.
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