How to invest in real estate with tax-sheltered accounts

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Many investors flock to real estate for the inherent tax advantages. Investors love the paper write-off of depreciation and love taking deductions on a separate tax schedule so they can still take the standard deduction. 

But what if you want even more? 

I aim to stack on new streams of passive income from real estate every month, and the more tax benefits I can get, the better. Different types of real estate investments call for different types of accounts, however. 

Consider the following a crash course on the available options for investing in real estate in tax-advantaged accounts

1. Publicly traded REITs

The easiest way to invest in real estate in a tax-sheltered account is to buy shares in real estate investment trusts (REITs). You can use a standard-issue IRA or Roth IRA from your brokerage. Even many workplace 401(k) or 403(b) accounts offer a handful of REITs as options. 

That means you avoid extra fees and headaches, you don’t have to hassle with specialized account custodians or IRS rules. More on those later.

Some people swear by REITs. Historically they’ve offered relatively strong returns, comparable to the stock market at large. They typically pay high dividend yields, sometimes even double-digit dividends

But for all that, they share an uncomfortably strong correlation with the stock market. I personally prefer other ways to invest small amounts in real estate

2. Real estate crowdfunding

The term “crowdfunding” can mean many different types of investments. 

In the real estate industry, it could mean funds that own many properties or loans secured by properties. Or it could mean fractional ownership of individual properties. Or it could mean individual loans secured by a property

Most real estate crowdfunding platforms require a long-term commitment, often five years. But retirement investing is a long-term game anyway. 

To invest in real estate crowdfunding with a tax-advantaged account, you’ll need a self-directed IRA or solo 401(k). In turn, that requires you to hire a custodian.

“In my opinion, starting your journey with a self-directed Individual Retirement Account (SDIRA) that permits real estate investments is the way to go,” explains Sam Wilson of Bricken Investment Group. “Your SDIRA will serve as the owner of the real estate assets, and all income and expenses associated with the investment should be channeled through the IRA.”

Self-directed IRA custodian fees typically cost between $150-500 per year. As you compare options, make sure you ask them specifically about whether they allow the specific real estate investments you plan to utilize.

3. Real estate syndications

When you ask middle-class investors about real estate investing options, most only understand direct property investing such as rental properties and flipping houses. Some know a little about REITs and crowdfunding. Almost none know anything about private equity real estate syndications. 

These group real estate investments effectively give you fractional ownership in large properties like apartment complexes. The returns can be impressive, often targeting 15 percent to 30 percent annually. You get all the benefits of owning real estate, including cash flow, appreciation and tax advantages, without any of the headaches of becoming a landlord. 

Like all investments, real estate syndications come with risk. These include many of the standard risks of real estate: interest rates and cap rates rising, poor management, high turnover rates, low occupancy rates, and the like. But you avoid several other risks that direct owners typically take on, such as legal liability and personal guarantees on debt service. Passive investors in syndications don’t take on those risks. 

The two greatest challenges for most investors looking to get started with real estate syndications are finding reputable sponsors (lead investors) and affording the high minimum investment. Under federal law, sponsors can’t advertise real estate deals to the public if they allow non-accredited investors to participate. Most syndication deals also require a minimum investment between $50,000 and $100,000, which is especially difficult if you invest with an SDIRA that you can only contribute $6,500 to each year. 

4. Direct ownership

The hardest way to invest in real estate with a tax-sheltered account is buying properties directly. 

To begin with, the IRS imposes specific rules about what you can and can’t invest in. “It’s crucial for investors to understand the specific rules and limitations associated with such investments,” explains Brian Meiggs of My Millennial Guide. “That includes prohibited transactions and the types of properties that can be purchased.”

For example, you can’t use SDIRA funds to house hack, because it benefits you as a disqualified person. Similarly, you can’t use the funds to operate your own business, such as flipping houses. 

“Because you are doing all of the work yourself, the IRS considers it your business, and using your retirement account for personal gain, not for the benefit of the retirement account,” warns Robert Taylor, The Real Estate Solutions Guy. “Doing a prohibited transaction with your retirement account can put your entire account at risk. I have an acquaintance who flipped houses using their own retirement account. The IRS audited their IRA and fined them $1,000,000.”

You also run into complications when you go to finance a property purchased by your SDIRA or solo 401(k). You can only borrow non-recourse loans, which means you can’t work with most mortgage lenders. Also, only the non-financed portion of the property gets preferential tax treatment. That means you need to report the returns separately for different portions of the property, some getting tax benefits and others not. 

Another option: Borrow from your 401(k)

All those rules get thorny quickly if you want to buy properties in the name of your SDIRA or solo 401(k). But you can take an alternative route: you can also borrow money from your 401(k) to invest in real estate. 

That avoids the complicated rules outlined above since you buy the properties outside your tax-sheltered account. You still get to use funds from your 401(k) to buy them, however. 

These loans come with plenty of restrictions, of course. You can only borrow up to $50,000 or 50 percent of your account balance (whichever is lower). You must also repay the loan in full within five years, or the IRS classifies it as an early distribution. 

Note that you don’t necessarily need a solo 401(k) to borrow funds — many workplace 401(k)s allow loans. Schedule a call with your 401(k) administrator to learn more about the rules and restrictions if this strategy appeals to you. 

Speak with a specialist

By now, you should be starting to get the sense that the rules get complicated quickly if you want to buy properties under the name of your SDIRA or solo 401(k). “Before you dive into this, it’s a smart move to chat with a tax pro or financial advisor,” cautions Kerry Sherrin of Ownerly. “They’ll take a good look at your situation and figure out the best tax shelter or investment types for you.”

If you only want to invest passively in real estate, such as in crowdfunding or real estate syndications, the rules are simpler and your custodian can handle the paperwork for you. Speak with several custodians to get a sense for their services and pricing before committing. 

Tax law gets complicated quickly. Get expert help if you want to optimize your tax bill with real estate, because the last person you want to tangle with is Uncle Sam. 

G. Brian Davis is a real estate geek and co-founder of SparkRental.

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