It’s really remarkable what you can learn from public officials if you look at their tax returns. Mitt Romney’s tax return provides lessons and strategies people not as wealthy as him can learn and use to create generational wealth for themselves. Although Mitt Romney is not a client of mine I always look at the tax returns of public officials because they give me tactics to you. I want to share one that I got from Mitt Romney and that he does the opposite of what the typical employee does he concentrates 100% of his investing strategy on investments he can control. Over the course of Mitt Romney’s professional career he built up a pretty large war chest in his 401k. Then he did something that majority of people in this country have no idea you could do. He took his IRA and 401k switched it to a self-directed IRA and multiplied his wealth rapidly. We all could learn from Mitt Romney he focused his investment to assets he could directly control. You’ve seen the advertisements and news articles. IRA and 401K funds can be used to make real estate investments or even investment in startup companies. But before you jump on this bandwagon, make sure you understand some of the tax planning angles related to this opportunity.
Passive Loss Deductions
Almost always, an important component of your real estate profits comes from the tax savings associated with depreciation. These paper losses, referred to as passive losses by the Internal Revenue Code, can save both small and professional real estate investors thousands of dollars a year in income taxes. Unfortunately, passive losses from depreciation and related, similar tax deductions won’t benefit real estate investors investing through IRAs.
Capital Gains Preferences
If you sell an investment for a profit—whether a stock or real estate—you get a tax break because your profit gets taxed at a preferential capital gains tax rate. In the best case scenario under current tax law, for example, your capital gains get taxed at 15% rather than at 35%.
Unfortunately, by putting real estate inside of an IRA, you lose this benefit. In effect, the appreciation you enjoy from your real estate investment gets taxed at your marginal income tax rate rather than at the capital gains rate. (Fortunately, the tax gets paid when you withdraw the money.)
Note: This “problem” also exists for other investments that produce capital gains, such as stocks and mutual funds that invest in stocks.
Unrelated Business Income Tax
In certain special circumstances, an IRA needs to pay income taxes on the profits it generates. These taxes, called unrelated business income taxes, essentially put the IRA investor in the same position as a regular taxable investor.
For example, if you’re developing and then flipping properties inside your IRA, you may actually be an active trade or business. And in this case, your real estate investment or business for that matter—even though it’s inside an IRA—may be subject to income taxes. (Your IRA custodian is supposed to report your taxable income and tax liability, and then pay the taxes but many don’t…)
And here’s another example of a situation where the unrelated business income tax can trip you up. If you borrow money to invest in real estate—the typical situation in any leveraged real estate investment—the profit you earn on the money you’ve borrowed is treated as unrelated business income. Accordingly, that profit is subject to unrelated business income tax.
Unrelated business income inside an IRA is taxed according to trust taxation rules, which means that as soon as you’ve made much money at all, you’re taxed at the highest marginal tax rates. Ouch.
Real estate is a great investment. And real estate belongs in any investor’s portfolio. But you need to think carefully about buying into the idea of using your IRA to make real estate investments. If you do decide to invest in real estate through your IRA, first consult with your tax advisor.
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The article was created by A. Donahue Baker, a CPA, an entrepreneur and Real Estate Developer.