Many of our clients are attracted to Self-Directed IRAs because they are a great way to hold income-generating investments while sheltering them from income taxes. Real estate is a great example: Real estate typically generates substantial rental income – especially when you account for the effects of leverage. In a taxable account, Uncle Sam takes his pound of flesh out of that rental income at ordinary income rates, though the taxes are offset somewhat by deductions for depreciation and interest income. Even so, you still have to pay those taxes before reinvesting that money for the next year.
Within a Self-Directed Real Estate IRA – a subset of Self-Directed IRAs – you do not have that problem: Income attributable to your own investment, as opposed to leverage, is not subject to taxation in the current year. In a traditional Self-Directed IRA, it is deferred until you begin taking money out of the account, which you should be doing beginning not later than April 1st of the year after the year in which you turn age 70½. In the case of a Self-Directed Roth IRA or Self-Directed Real Estate Roth IRA, that money grows tax free as long as it remains in the account (as long as it stays in the account for at least five years.
Only the amount of income attributable to leverage is subject to tax, under unrelated debt-financed income rules. So, if you own a Self-Directed IRA property worth $200,000, and you have a mortgage for 50 percent of that amount on the property, you just have to pay taxes on 50 percent of your rental income. As your property value grows and you pay down the mortgage over time, the fraction of income you have to pay taxes on gradually falls.
What to do with cash flow within a Self-Directed Real Estate IRA.
First, let’s talk about what NOT to do:
DO NOT let your tenants write you a rent check directly. If you take a check directly from your tenants, the IRS will count that as a distribution, and you could be subject to unwanted taxes and penalties. It could potentially result in the IRS stripping your entire Self-Directed Real Estate IRA of its tax-protected status.
Instead, the check needs to be made out to the Self-Directed Real Estate IRA that owns the property. Generally, that means the checks are mailed to American IRA, LLC, which deposits them into your account on your behalf. Some investors who use the ‘checkbook control’ approach to Self-Directed IRAs can deposit these checks directly into a bank account in their Self-Directed Real Estate IRAs name. But more than a few Checkbook Control IRA investors have gotten into hot water with the IRS for inadvertently or deliberately mingling their personal and IRA funds.
Our clients use monthly cash flow from Self-Directed Real Estate IRA rental properties for the following priorities:
- Depositing in a money market sweep account or checking account to build up cash reserves against future emergencies and repairs;
- Paying down mortgage balances – thereby reducing future exposure to unrelated debt-financed income tax.
- Making needed repairs.
- Upgrades/capital improvements.
- Marketing the property and paying real estate commissions.
- Down payments toward other Self-Directed Real Estate IRA properties and other IRA investments.
- Putting in vending machines, washing machines and other cash generators in multi-family Self-Directed Real Estate IRA
- Buying furniture for apartments they want to market as furnished.
- Paint, landscaping and other ‘curb appeal’ improvements.
- Property management fees.
- Legal fees specific to the Self-Directed Real Estate IRA (e.g., LLC or corporation filing fees).
- Insurance premiums covering the Self-Directed Real Estate IRA property.
As you can see, while a Self-Directed Real Estate IRA property can deliver substantial cash flow – especially after you have owned it for a while and you have had time for several rent increase cycles while your mortgage payments stay flat.
But there is no shortage of options and priorities to commit your free cash flow to within the Self-Directed IRA – and you do not have to risk violating tax laws and incurring prohibited transaction penalties in order to productively reinvest your Self-Directed Real Estate IRA rental property positive cash flow.