Over the last year, a number of interesting questions have come up about tax-free real estate deals.
Is there a risk in doing too many tax free real estate deals in your Keogh or IRA
(also known as the Dealer issue)
What is the difference regarding transactions in a Roth IRA versus a traditional one?
And the ubiquitous Unrelated Business Income Tax question…
The answers to these are not always straightforward:
Based on information we received as recently as 2004 from the same prominent real estate and ERISA attorneys, the dealer issue is now a questionable matter. There are a number of means tests which could be applied to tax deferred plans. These tests are based on case law related to capital gains treatment for dealers and non-dealers. No case law deals with IRAs or Qualified Plans. Intent to act as a dealer, holding real property for sale to the general public and other such issues need to be addressed through competent legal counsel, such as Richard Lipton at Baker & McKenzie in Chicago.
Doing a transaction in a Roth IRA and a traditional IRA is significant in a number of ways:
All funds, including profits in a Roth are tax-free forever. You can withdraw the basis (the amount you paid taxes on) from your Roth at any time. You cannot do this in a traditional IRA setting. You may begin distributions (withdrawals) from either plan type at 59 ½, but you must begin distributions in the year following turning 70 ½ from a traditional IRA. Roth IRAs have no such age requirements. Yes, you can take withdrawals in kind.
Unrelated Business Income Tax:
For Real Estate, if you have a debt financed property you are subject to Unrelated Business Income (UBI) tax in an IRA, but not in a qualified plan, such as a Keogh. You get to take depreciation and other expenses into account in calculating UBI, and are subject to tax if you have over $1,000 profit. If you are out of debt financing for a year prior to sale, you are not subject to UBI. Don’t leverage a property you plan to sell within a year; leverage another one instead.
The real deal remains in Roth IRAs:
We just did a deal where we bought two houses as fixers in a Roth. Using $63,000 in the Roth of basis money (money on which tax had already been paid), we bought two fixers at $31,000 and $32,000. After two weeks, the first is sold at $56,000, and the second at $48,000, for a total profit of $51,000. The total account value was $114,000.
On to the next deal, we used $50,000 for another fixer, which we flipped for $75,000.
The profit of $25,000 boosted our Roth up to $139,000 which had started with less than half that amount in four weeks time. Needing some cash for incidentals is easy in this case. We pulled out $30,000 from the Roth. The $30,000 was not taxed, as it was part of the basis of $63,000. This leaves us with a basis of $33,000, and a total asset value of $109,000.
So we have a lot to make more deals with, and we could still pull another $33,000 out without tax consequences, before age 59 ½ We can do these deals all day long!
If you have a profit sharing plan, and own your own business look into the in-service withdrawal provision. You can take assets from your Keogh plan and roll them to an IRA even when you are still making profit sharing contributions. You can pay tax on that IRA and convert it to a Roth (if you qualify). Why is this a good deal? If you have real estate in your Keogh, you roll it over at its last appraised value, or at the value you just bought it at (See the Roth item above). You pay tax on that value to convert to a Roth. Some quick math will show you how profitable this can be for you.
These are but a few of the creative ways to do real estate deals.
When it comes to using IRAs and Qualified Plans, your options increase what you may already be doing in your daily life as a real estate professional or as an investor. The IRS code can be a great ally in your present as well as your future. It is just a matter of how you use it. Please just don’t ask anyone to look the other way when you contemplate a prohibited or self-dealing transaction. You can do to many things safely and legally. Remember if it sounds to good to be true, it is to good to be true.