By Dave Rowan, CFP®
Most people do not like paying any more in taxes than they absolutely have to by law. Fortunately, taxpayers will be getting some relief. If you’re married filing jointly and making between $165,001-$315,000, you’ll pay 24% when you file your 2018 taxes in 2019. This compares to 28% for the roughly equivalent bracket in 2017. And top earners making over $600,000 will see their marginal tax rate reduced from 39.6% in 2017 to 37% in 2018.
Common Tax-Saving Strategies
Despite these reductions, you will still be shipping a significant portion of your hard-earned income off to the government, leaving you and many other Americans searching for the best tax reduction strategies available. Traditional strategies to reduce taxes include saving within an employer-sponsored retirement plan such as a 401(k) or 403(b). This is a particularly valuable strategy given that employers often match your contributions up to a certain percentage.
If you’re not eligible for an employer-sponsored plan, you can save within a traditional IRA; however, contributions are limited to $5,500 per year, or $6,500 per year if you’re over 50. You can also consider a flexible spending account (FSA) or health savings account (HSA), which allow you to pay for medical expenses in pre-tax dollars. Each has its own rules and contribution limits and will continue to peck away at your tax bill in small bites.
Business owners have some bigger levers to pull to save for retirement. One of the best is the SEP IRA, which allows business owners to contribute the lessor of $55,000 or 25% of taxable income into their retirement plan. The downside is if you contribute 25% of your income to your plan, you must also do the same for every eligible employee. So while this plan is a great approach for solopreneurs, it is a poor choice for businesses with employees.
Let’s say you’ve used some or all of these strategies and brought your taxable income down by $30,000 or so. Are there any options left? The short answer is yes, if you have an IRA account of some type and are willing to invest in real estate.
1. Can I Buy Real Estate Within an IRA Account?
It’s a little known fact, but yes, you can indeed buy real estate within an IRA account.
2. What Types of IRA Accounts Can I Use to Buy Real Estate?
Examples of the types of IRAs that can be used to buy real estate include traditional IRAs, Roth IRAs and SEP IRAs. The account must be self-directed to qualify.
3. What Are the Main Advantages of Using My IRA to Invest In Real Estate?
One of the biggest advantages is all profits generated from the venture return directly to your IRA and remain there on a tax-deferred basis. So, for example, any appreciation in the value of the property remains tax-deferred as long as that property is owned within the IRA. Most investors only buy stocks and bonds within their tax-deferred IRAs. Using a portion of your tax-deferred savings to buy real estate is an excellent diversification strategy and ensures at least a portion of your retirement savings is not subject to the volatility of the stock market.
Finally, buying real estate with after-tax dollars is often not an option for people who have most of their savings tied up in tax-deferred accounts. This is often a great way for investors to get started with real estate investing by tapping into a portion of the wealth they have accumulated in their IRAs.
4. I Have My IRA Parked at TD Ameritrade – Can I Use That to Buy Real Estate?
No, traditional asset custodians such as TD Ameritrade, Charles Schwab or Fidelity have no interest in this segment of the IRA market. Asset custodians that do handle these types of investments include Pensco, Nuview IRA, Equity Trust Company, CamaPlan and many others.
5. I Participate in My Employer’s 401(k); Can I Use That to Buy Tax-Deferred Real Estate?
Maybe. One of two things must be true. Either you must have complete self-direction within your plan or your plan must allow you to roll over some or all of your account balance into a self-directed plan. Check with your plan administrator to see if either or both of these conditions are true.
6. Can I Use My IRA to Pay for Property I Already Own?
No, the IRS considers this to be a form of “self dealing” and defines you as a disqualified person who is not allowed to participate in this type of transaction.
7. Can I Purchase a Vacation Home With My IRA?
Once again, the answer is no. You may not have “indirect benefits” from the property owned by your IRA.
8. How Can I Get Money into My IRA Account Faster?
One of the great aspects of this investing niche is it is possible to borrow money and deposit it into your self-directed IRA to help fund your real estate purchases. Traditional lenders usually do not like making these types of loans, typically only offering a 60% LTV ratio and often requiring 20% in reserves. You are much better off seeking private money for loans into your IRA, although the answer to the next question explains the limits to this approach.
9. What Rules Govern How I Can Borrow Money to Fund IRA-Based Real Estate Transactions?
Technically, it is not you who is doing the borrowing, your IRA is the borrower in the transaction. In addition, your IRA must also be the owner of the property that you purchase with the borrowed funds.
There are also limits on who can loan you the money. Close family members such as children and their spouses, grandchildren and their spouses and parents and grandparents are disqualified persons and can’t give you a loan for this purpose. On the other hand, siblings, nieces, nephews, aunts, uncles and cousins are allowed. IRS Code 4975 and Publication 590 offer additional information.
10. Are There Any Tax Implications to Using my IRA to Invest in Real Estate?
I’d love to say no, but unfortunately the answer is yes. When your IRA borrows money to purchase real estate, it will probably be taxed on a percentage of the amount borrowed. This is known as unrelated debt financed income (UDFI) and is taxed at trust rates. It is important to have a tax professional who thoroughly understands and can explain the tax rules associated with this type of transaction so you can make a well-informed decision on what is right for you.
For some people, using their IRA to invest in real estate is a great strategy to reduce their taxable income. Before you jump into it, make sure you have all your questions answered and that it is the right move for you.
Recent articles from Dave Rowan: 9 Steps to Invest in Rental Real Estate
This article was originally published on Investopedia.