Using IRA to Purchase Real Estate | Residential Brokerage Education in Minneapolis MN
Tom Sedlack - Wednesday, February 22, 2017
Our realty and brokerage services in the Minneapolis Twin Cities Metro area can include the purchase and brokerage of real estate using an IRA conduit to make that purchase. A lot of people ask if it’s a good deal, and whether they should put that real estate in their IRA or keep it out of their IRA.
An IRA – Individual Retirement Account – is a great instrument to have in protecting yourself from the tax bite of appreciating financial assets. Putting your money into real estate can also help, and in many cases, real estate already has significant tax benefits that people are not aware of.
Since most real estate already enjoys tax write-offs through depreciation, expenses, and many other vehicles like 1031 Exchanges and trusts, real estate already has a very good venue to protect yourself from taxes. So, if you put real estate into your IRA, it’s almost a redundant situation where you have tax benefits and then you’re putting them into a tax-protected IRA. In some cases, an IRA can limit your flexibility when it comes to real estate. So, we’ll talk about some examples.
Tax Deductibility of Real Estate
Typically when you fill out a Schedule E for residential rental properties, effectively you have three things going into that Schedule E: income; expenses; and, depreciation. For a typical $300,000 home, $25,000 is about the value of the land and $275,000 is the value of the structure. You can put that property into your Schedule E and deduct the depreciation off that $275,000 structural value. So in that sample property, maybe you get $1,500 in rent. Your Schedule E will look like this:
Annual income: $18,000
Your expenses are going to be your mortgage interest, property taxes, HOA fees, insurance, property management fees, and any other expenses related to that property. In fact, you can even include ancillary expenses like travel. Many of our owners live around the world, and when they fly back to the city and drive past the property, the entire trip becomes a business expense. You can also include subscriptions to trade journals or real estate magazines. Home office expenses are also potentially tax deductible. So our expenses on this sample property could break even:
Taxes and other
So at the bottom of your Schedule E, you will put your depreciation. This is 27-1/2 years for residential properties. So take your $275,000 home value and divide it by 27.5. You get a $10,000 annual depreciation expense that you can deduct. Now, when you add up Schedule E, you no longer have a break even situation, you have a paper driven loss driven by depreciation. That $10,000 loss as an investor will scoot over to Line 17 on your 1040, and you have reduced your taxable income by $10,000. If you’re in the average tax bracket, you just saved $4,000 in taxes. Divide that by 12, and it’s about $330 a month you’re getting in tax benefits. Even outside of an IRA, real estate brings you a significant tax benefit.
Using Your IRA as a Reserve
Many investors prefer to opt out of putting real estate in their IRA. They’d rather protect investments that are not tax-deferred like financial investments - stocks and bonds – inside their IRA, and then outside of that, they want the real estate. The nice thing is you can double dip.
Your IRA contains a multitude of things, like stocks, bonds, mutual funds, and all of your portfolio assets. Then, you can buy a rental property outside of your IRA. But, you can use the IRA value to establish the reserve value on loan for that rental property. Typically, banks use a 75 percent metric to determine the value of an IRA or 401K as a reserve for your rental property. A six month reserve is usually required, so if you have a $1,500 rental property, you’ll need $9,000 in your IRA reserves to support your mortgage.
Because you need 75 percent, you’ll need $9,000 in your IRA, which will be divided by 75 percent, and you’ll need about $12,000 in that IRA to support your reserve to purchase a home. This is typically the way IRAs are used by investors to support their rental activities.
As far as managing rental properties, if you have a property within an IRA, a talented property manager can handle that. There is some additional reporting that’s necessary, and an account that has to be given to your property manager because all the rent distributions will be deposited into the IRA account, and some banks don’t allow ACH automatic receipts. So, there might be some manual check writing to accommodate the bank requirements.
When you work with your IRA reserves and your mortgage requirements for rental property, you’ll get the most bang for your buck.
Here’s our disclaimer: we are not attorneys or CPAs, and the advice we have is based on our own experience and knowledge. You should always seek the advice of a tax professional to confirm the best path forward for you when it comes to investing in real estate.
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