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Tax issues abound in IRA realty investing

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07-06-2006

By Lew Sichelman, MarketWatch, REAL ESTATE, Realty Q&A

WASHINGTON (MarketWatch) -- Question: If you financed the property in your IRA would that not be debt-financed income, triggering UBTI [Unrelated Business Taxable Income] in your IRA and significantly nondesirable tax results? You would have to file a tax return annually for your IRA and, perhaps, pay income tax annually within the IRA before you withdraw any amounts for retirement. See previous Realty Q&A.

Answer: Your question and dozens of others on this topic are way beyond my rudimentary knowledge of using retirement monies to invest in real estate. So I asked Hubert Bromma, chief executive officer of the Oakland, Calif.-based Entrust Group, to weigh in. Bromma's company manages more than $2 billion in retirement assets, most of which is in real estate. He has 25 years of experience and is the author of a new McGraw-Hill book, "How to Buy Real Estate With Your IRA and 401(k)," coming out later this year. Here's his response:

"In any IRA, one incurs an unrelated debt finance income tax if the asset is leveraged. The portion which is leveraged also receives the benefits of write-offs, such as interest and deprecation expense. So the real tax bite occurs if a property sells while still debt-financed, and the profit (after expenses and recapture of depreciation) is over $1,000.

"However, the tax is at the capital-gains rate and only on that portion that has remained debt- financed on sale. In other words, the entire profit is not taxed, and the results are not taxed again until they are distributed in any other IRA than a Roth.

"Clearly, debt financed transactions are better in a Roth vehicle, such as a Roth IRA or Roth 401(k), where there is no tax on distribution. Think about a 100% debt-financed transaction in a traditional IRA. If the profit on a $100,000 asset is $50,000, the capital gains is, say, $10,000, which is paid by the IRA. That leaves $40,000 tax deferred for future investment. Sounds like a good deal to me."

Q: If there is debt on the property and a profit from renting it, there will be UBIT on the "debt-financed" portion of the property. UBIT creates a double tax situation because the account owner is taxed again on the income when it is distributed.

A: Again Bromma:  "That is correct.  But in the interim, the account has been earning tax free. That is why the Roth is so much better.

Q: How about RMD [required minimum distribution]? What is the value of the house at the end of the year? You will need an independent appraisal every year, which is another cost. Real estate is always better held outside of an IRA due to it's inherent illiquidity, leverage, tax shelter and capital gain treatment on sale or exchange flexibilities under IRC Sec 1031.

A: "You will need a Fair Market Value Determination for RMDs," Bromma responds. "That does not mean a full blown appraisal. You could use comparables or recent offers."

The retirement plan administrator also says the liquidity issue is no different in or outside an IRA. "Cash flow can make up RMDs, and a sale inside the IRA does not result in an immediate tax and never in a Roth," he says.

Bromma's book, due out in the fall, will compare the differences between owning real estate the conventional way versus in an IRA. And he says that personal ownership always comes out last. "We did an eight-way comparison, leveraged and unleveraged," he says. "The conclusions are interesting, and the Roth and 1031 strategies are always on top."

By the way, Bromma's overall advice on using retirement funds to invest in real estate is, plan, plan and plan some more. "Planning is the key," he says. "Personal objectives, cash, leverage, time all play major factors. One cannot go blindly into any option without being clear about his personal end game."

Q: I sold a company and retired in 1989, and I live on investments and now a little Social Security. I have not used any of my IRA yet. But can I contribute even though I am retired and not working? Also, can I contribute from investment income for my 52-year-old wife, also not working?"

A: Hey, I know this one. To contribute, you must have earned income.

Feedback

I was incorrect in last week's response to a question concerning property taxes. The question was California-specific, and my answer was too general because I did not pay enough attention to the reader's location. Many thanks to the myriad of readers who pointed that out. See previous Realty Q&A.

Because of Proposition 13, property taxes in California are based solely on the most current selling price. Consequently, two identical homes, side-by-side, rarely are taxed the same. If one was last sold 20 years ago and the other changed hands just six months ago, the owner of the first place will be paying a much lower property tax than the owner of the second one. And this is what the reader was referring to.

However, the rest of last week's answer remains the same: Reader Kathie Carmer, a real estate agent, wanted to know why the tax is based on the total selling price, when the total includes a hefty sales commission that is often in five figures, especially in the Golden State, where prices are exorbitant. And I answered that the commission is part of the price because it's stated that way on the sales contract.

If it was stated separately -- such as $300,000 for the property and $18,000 (6%) as the broker's fee, rather that $318,000 in one lump sum -- the property tax would be lower.

Nationally syndicated columnist Lew Sichelman has been covering the housing market for 35 years. Because of the volume of mail he receives, he cannot answer individual questions, nor can all questions be answered in this space.

E-mail lsichelman@aol.com