Self-directed IRA - Roth or Traditional

[michellesmith]

I plan to purchase a rental property in a self-directed IRA. Other than the different taxation of the two, is there anything else to consider when I decide whether to fund my SD-IRA with traditional IRA funds or Roth funds. I have both Roth and Trad accounts to pull from.
Also, is it true that if I finance, let's say, 25% of the value of that property, even though it is in a tax-sheltered account, that the IRS will count 25% of the rental income as taxable income?

[krow36]

Jane Bryant Quinn has a long list of reasons why using IRA funds for real estate rental property in an self-directed IRA is not a good idea. The book is “How to Make Your Money Last: The indispensable Retirement Guide”. Perhaps you’ve read it? She discusses self-directed IRAs in Chapter 7.

[David Jay]

Are you really sure you want to do this?

Direct quote from this thread: viewtopic.php?t=235568#p3681566

"I recommend going to biggerpockets.com and looking at the threads pertaining to this. Dmitriy Fomichenko and Mark Nolan are very responsive and can give you answers specifically related to rental real estate. Keep in mind that all ongoing expenses (including property management/taxes/repairs) have to come from the account (hopefully covered by the rent) and all rent has to be returned to the IRA. You also lose all of the real estate related tax benefits by purchasing the property in your SD IRA so make sure it's a great cash-flowing deal. Best of luck."

[jimb_fromATL]

I plan to purchase a rental property in a self-directed IRA. Other than the different taxation of the two, is there anything else to consider when I decide whether to fund my SD-IRA with traditional IRA funds or Roth funds. I have both Roth and Trad accounts to pull from.

There is no difference in taxation within either type of IRA, because there are no extra tax breaks for rental property within IRAs. Since rental real estate is an unusually good way to get leverage and tax breaks outside of IRAs, IMO it does not really make any financial sense at all to hold a rental property within an IRA.

In fact IMO about the only people who even suggest that you invest in individual parcels of real estate within self-directed IRAs are the people who make their money by managing your property for you, since you’re not allowed to do anything with it for yourself.

The following is mostly from my post in another thread on the subject:

• This article at bankrate.com discusses: Why real estate investing in a self-directed IRA makes no sense
  
  Another article at Kiplinger's about the pitfalls of self directed IRAS.
  
  Here are some links to FAQs from the IRS about “prohibited transactions” and other problems with real estate and other investments within self-directed IRAs:
  
  https://www.irs.gov/retirement-plans/re ... ments-faqs
  
  https://www.irs.gov/retirement-plans/pl ... ansactions
  
  Just some things to think about, gathered from other discussions:
  • You cannot manage or maintain a rental property within an IRA yourself or have a family member do it. You cannot put in “sweat equity” to fix it up to flip it for profit or to rent it out. You cannot use it for yourself, buy it from your IRA, or buy it from or sell it to a family member.
    
    Because of the rules against self-dealing, you have to pay a “custodian” to manage your investment for you, and to do all the maintenance and repairs. That alone would eat up a lot of any potential gain.
    
    The rules are so complicated that there are a lot of mistakes made, even by the pros. And because it is so misunderstood there is an awful lot of misleading information and outright fraud by the people who encourage you to pay them to manage it for you. Then if you or your custodian make a mistake in the complicated rules about "arms-length" and prohibited transactions, the IRS will probably count it as a premature withdrawal with taxes and the early withdrawal penalty.
    
    Even in the best case of finding an honest and competent custodian to manage it for you, then you would essentially lose all of the tax breaks and advantages that are normally associated with real-estate investing for property that is outside of retirement accounts.
    
    Among other problems, you lose the advantage of leveraging, since no lender is likely to be willing to give your IRA a mortgage at a viable rate, and you cannot personally guarantee the loan.
    
    Within an IRA you cannot deduct any expenses like property taxes, insurance, maintenance and repairs, advertising, travel expenses, management fees, or the depreciation allowance. All of those are things are what can make real estate investing profitable outside of retirement accounts, but are of no benefit within an IRA.
    
    You also lose the opportunity to use any losses (either real or “paper” losses) to offset other income for tax purposes. Any profit it might make is also reduced by the extra fees you must pay the custodian and maintenance and repair folks, since you’re not allowed to do anything with it for yourself.
    
    Then when you sell it you pay regular income tax on the gain in your highest bracket when you withdraw it from your IRA, instead of the lower long term capital gains tax rate.
    I don't know for sure, but here's something else that comes to mind for further research:
    • It occurs to me that in a tax deferred IRA you might also run into problems with RMDs (Required Minimum Distributions) after age 70½. (Although as I understand it, there may be a way to sell off partial shares of the property within the IRA to yourself to meet the RMD requirement, but it seems to me it would awfully complicated to have partial ownership in a property that you're not allowed to manage by yourself because of the arm's length rule.)
    Even if RMDs are not an issue and/or you have enough other funds in your IRA(s) to meet the RMD requirement while you're alive, your heirs will eventually have to pay regular income tax on the sale of the home when they inherit your IRA ... and it will be on all the gain in value since you bought the property.
    
    (If they inherit a home from you outside a 401(k) their cost basis becomes its market value at the time of your death, so they could sell it at current FMV with no tax at all.)
    
    Plus you if you decide you don't want to keep an investment property outside an IRA, you can defer taxes on the gain virtually forever by doing a 1031 exchange for another investment property that might be more conveniently located.
    
    You can also get some equity out of a normal investment property with taxes still deferred by borrowing against its equity. Not so if it's in your IRA.

  Also, is it true that if I finance, let's say, 25% of the value of that property, even though it is in a tax-sheltered account, that the IRS will count 25% of the rental income as taxable income?

  
  Not true for several reasons.
  • The main one is mentioned above -- that you cannot finance it within an IRA. Remember, you cannot personally guarantee the loan payments, and you cannot use an IRA as collateral. In the unlikely even that your custodian or somebody else would make an unsecured loan with no personal involvement from you, , the rate would not be favorable, and you would not get to deduct any of the mortgage interest to offset other income from year to year.
    
    Plus, you do not have any income from the property from year to year. All of the gain from rent and appreciation -- assuing there is any after all the expenses of paying a custodian -- cannot be touched until retirement time without paying regular income tax PLUS the 10% penalty for early withdrawal.
    
    Even after retirement, there there are no tax breaks like you would get from rental property outside an IRA. You pay regular income tax on ALL of the gain as you withdraw the money from your IRA.
  To reiterate all over again, rental real estate does not make any real financial sense within an IRA.
  
  After you've maxed all available tax deferred and tax-advantaged retirement investments like 401(ks) and IRAs, and after you have plenty of funds set aside for emergencies, and after you have virtually no other debts and/or have a plan for paying off your own home within a few years, then if you have the temperament and patience to be a landlord, and don't mind the hassle and risk, rental real estate can be a good place to invest after-tax money in taxable accounts.
  
  jimb

[David Jay]

Wow Jim, what a great primer!

Hope Michelle is willing to read the whole thing and follow the links.

[michellesmith]

Thanks so much everyone for the info! I can't wait to dive into every bit of it.