Should you hold rental real estate in a self-directed retirement account? Is real estate a great asset to own in a Roth IRA? Is holding real estate in a self-directed retirement account a hack that can help supercharge your path to financial independence? Below I discuss what it looks like to hold real estate in a self-directed IRA or 401(k), with a particular focus on those looking to achieve FI.
A Necessary Predicate
Before I proceed, I need to lay a necessary predicate. Those actively pursuing financial independence will fall into one of the two following groups:
Group 1: Invest in a diversified portfolio of equities and bonds.
Group 2: Invest in real estate and a diversified portfolio of equities and bonds.
Why is there no third group, real estate investors only? For two main reasons. First, many pursuing FI have no interest in owning rental real estate and/or desire to only own a small number of properties. Second, as a general rule, investing in only one sector of the economy (technology, financials, pharmaceuticals, utilities, real estate, etc.) leaves an investor dangerously undiversified and vulnerable to very particular risks to a degree diversified investors are not.
The rest of this post focuses on tax basketing for individuals in Group 2: those pursuing FI and investing in rental real estate and a diversified portfolio of equities and bonds.
Stock Basis vs. Real Estate Basis
Recall that the basis of stock, bonds, mutual funds, and ETFs (what I will colloquially refer to as “stock basis”) is the amount you paid for the asset plus any distributions reinvested in the asset less any nondividend distributions (returns of capital). Stock basis is great, but for many in the FI community, its benefits are distant and significantly eroded by inflation.
Picture Jack and Jill, a married couple, each 25 years old and actively pursuing financial independence. They max out their IRAs and workplace retirement plans. They have a savings rate in excess of 50 percent, so they must invest in taxable accounts, and choose to invest in low-cost, well diversified index mutual funds. They target early retirement at age 40.
Other than very occasional tax loss harvesting, the basis Jack & Jill obtain in their taxable mutual fund accounts at age 25 will be meaningless to them until they are at least 40 years old. Even then, using something like the 4 percent withdrawal rule, they will touch only a small fraction of their basis every year. By then, the value of the basis they put in the mutual funds will have been significantly eroded by inflation.
But what if Jack and Jill instead decide that they will max out their IRAs and workplace retirement accounts (using stock and bond index funds), and then everything else will go into taxable rental real estate investments. What value does their basis have then? Much greater value, it turns out. Jack and Jill can immediately depreciate their rental real estate and start using their basis to reduce their taxable rental income from that property and other rental properties. Depending on their circumstances, they may be able to deduct some or all of any rental real estate loss against other taxable income.
When you invest in rental real estate in taxable accounts, your tax basis goes to work for you right away. When you invest in financial assets, your tax basis sits dormant, possibly for many years or the rest of your life. By the time you use your stock basis to obtain a tax benefit, the value of your stock basis (and thus the resulting tax benefit) may be severely diminished by inflation.
This strongly indicates you should house financial assets in retirement accounts and rental real estate in taxable accounts. House the rental real estate (pun intended) in taxable accounts where you can milk its basis for all it’s worth while housing the financial assets in retirement accounts.
Leverage and Tax Basis
You can use leverage to increase the tax value of rental real estate. A young couple will have to likely borrow some or all of the purchase price of their initial rental real estate investments. This can be advantageous from a tax perspective. Here’s an illustrative example:
Jack and Jill have $50,000 of cash to invest in a taxable account. They have decided to invest in a $250,000 fifth floor condominium to rent out. They borrow $200,000, purchase the property, and rent out the condo. In the first year they rent out the condo for a full year, they can get $9,091 ($250,000 divided by 27.5) in depreciation deductions and, assuming a 5% loan, almost $10,000 in interest deductions. Note this and all examples ignore any potential price allocation to land for simplicity.
Jack and Jill leveraged $50,000 into almost $19,000 in tax deductions in one year alone. Had they purchased $50,000 worth of financial assets, they would have received exactly nothing in tax deductions in the first full year, and the value of the $50,000 of basis would be eroding away to inflation. Even if they were able to tax loss harvest, at most the benefit would be a $3,000 deduction against their ordinary income.
In some cases, depreciation combined with other deductions causes rental real estate to produce a loss for tax purposes. Why put an asset that generates a tax loss in a retirement account?
If stock basis has such limited value, and rental real estate basis has such impactful, immediate value, why “exploit” stock basis in a taxable account while you neuter rental real estate basis in an IRA? It makes much more sense to utilize that rental real estate tax basis in a taxable account and put limited value stock basis in a retirement account.
Step-Up at Death
When you leave your heirs rental real estate in taxable accounts, the government gives your heirs hundreds of thousands of dollars worth of free tax deductions!
There’s no lack of content discussing the many tax benefits of real estate. Some of it discusses the step-up in basis at death and the ability to hold real estate in a self-directed retirement account. What little of this content acknowledges is that if you hold real estate in a self-directed retirement account, you lose the step-up in basis at death!
If you are at all concerned about Second Generation FI for your children, you need to consider this issue. The step-up in tax basis at death is an incredible opportunity for your heirs. Upon your death, your heirs get to re-depreciate your rental real estate based on the fair market value of the property at your death.
Here’s a comprehensive example.
Jake buys a small rental condo for $100,000 in 2019. He fully depreciates it over 27.5 years, saving significantly on his taxes. He dies in 2049 when the condo is worth $400,000. He leaves the condo to his adult son Jake Jr. He also leaves a Roth IRA with financial assets to Jake Jr. worth $400,000.
What result? Jake Jr. inherits the condo with a $400,000 tax basis and gets to depreciate that new $400,000 basis for 27.5 more years! This drastically reduces his taxable income from the property and may create a currently useable taxable loss. While Jake Jr. must withdraw the inherited Roth IRA within 10 years, the money from the Roth IRA is tax free to Jake Jr. And because Jake Jr houses the inherited Roth IRA at a discount brokerage (such as Vanguard, Fidelity, or Schwab), the Roth IRA pays minimal fees.
What if instead Jake had housed the financial assets in his taxable accounts and the rental property in his Roth IRA. First, the financial assets will produce interest, dividends, and capital gain distributions that will be taxable to Jake Jr. every year. Second, Jake Jr. will pay more in annual fees to a self-directed Roth IRA custodian. Further, Jake Jr. will lose the ability to claim any tax loss generated by the condo against his other income.
The effect is magnified if Jake Jr. leaves the rental property to his son, Jake III. Jake III will again get to step-up the basis in the condo to its fair market value when Jake Jr. dies and re-depreciate it! Over several generations the step-up in basis cycle can create potentially millions of dollars of tax depreciation deductions!
Rental Real Estate: Taxable Accounts and Retirement Accounts
If you are going to give up hundreds of thousands of dollars (possibly millions) of tax deductions for your heirs, you ought to have a compelling reason to do so. I do not believe there’s a compelling reason to house real estate in a retirement account and forego these free future tax deductions.
Roth IRAs are great for protecting the income generated by financial assets from taxation. The step-up in basis is great for protecting the income from rental real estate from taxation. Why waste a Roth IRA on real estate when your heirs will get a fantastic step-up in basis in your real estate to shield a significant portion of the income from taxation (and may possibly generate useable current real estate losses)?
All of this is magnified if the rental real estate is in a traditional IRA instead of a Roth IRA. Instead of depreciation and other deductions to shield rental income from taxation, every dollar you ever take from a traditional IRA will be subject to ordinary taxation (even if the underlying rental property is unprofitable). Combining this with self-directed retirement account custodian fees makes a traditional retirement account a terrible place to house rental real estate.
Stepped-Up Stock Basis
As discussed, the step-up in real estate basis is effective in reducing or eliminating taxable income rental real estate. But the step up in basis does nothing to reduce income from interest, dividends, and capital gain distributions generated by inherited financial assets. This further indicates that the step-up in basis is better used on real estate than on financial assets.
Other Considerations
Tax basis is not the only consideration in determining where to tax basket assets. Below is a run through of several other important considerations.
Costs
As of 2023, costs for investing in well diversified index funds in retirement accounts at discount brokerages are approaching zero. Costs for self-directed IRAs and 401(k)s are more substantial. Costs can include a set-up fee, annual account fees, one-off service fees, and fees for valuations.
Valuations
Starting at age 73, you must take RMDs from your traditional retirement accounts and employer Roth accounts. In the year after your death, certain heirs must take RMDs from your retirement accounts (including Roth IRAs). To do this, the recipient must know the value of each retirement account on December 31st of the prior year. For publicly-traded stock and bond based mutual funds and ETFs, the financial institution will simply report this information to you. For real estate, it is a very different ballgame. You will need to obtain a third party valuation, as the December 31st value of any particular piece of real estate is not readily apparent or known. This is an additional annual cost of owning real estate inside a retirement account.
Capital Gains
If you sell financial assets in a taxable account, you’re stuck with the capital gain, which will increase your federal (and possibly state) income tax bill. There are narrow and/or costly exceptions, including, the qualified opportunity zone program, which requires you to invest in a very specific type of investment that you may have absolutely no interest in investing in, for a minimum period of time. The qualified opportunity zone program can also apply to real estate capital gains.
The other exceptions to stock capital gain, including donations to charities, donor advised funds, and/or charitable trusts, are expensive, in that they require you to relinquish some or all of your economic ownership in order to avoid a taxable capital gain.
If you want to sell your rental real estate, you can use a Section 1031 “like-kind exchange” and simply exchange the rental property for another piece (or pieces) of rental real estate. This defers the capital gain on the sold property for as long as you hold onto the substitute property. Section 1031 exchange treatment is not available for financial assets.
While Section 1031 exchanges may not satisfy investors in every instance, the availability of Section 1031 exchanges is a reason to keep real estate in taxable accounts.
Rules, Rules, Rules
If you put your real estate in a retirement account, you voluntarily subject yourself to a whole host of rules. One is that you are not allowed to use the rental real estate for personal use. Another is that not allowed to personally manage or repair the property. Any violation of these rules can disqualify the retirement plan, resulting in a distribution of the property to the plan owner. This can result in a large taxable income hit and/or early distribution penalties if the owner is under age 59 ½.
Unrelated Debt Financed Income (“UDFI”) Tax
Is your rental property at all debt financed? If it is, and it is in an IRA, your IRA (including a Roth IRA) will be subject to income tax (the “unrelated business income tax”) on the portion of the taxable income that is attributable to the debt (the “unrelated debt financed income”). For example, if you have a condo that was purchased half with debt, half the income will be subject to tax (at the IRA level) as UDFI.
Further, as an entity your IRA is subject to taxation at very steep tax brackets. While the first $1,000 of UDFI is exempt from taxation, by the time the taxable UDFI exceeds $12,500, the IRA pays the highest individual marginal ordinary income tax rate (currently 37 percent) on the income.
There are UDFI workarounds. One is to roll a self directed IRA/Roth IRA to a self directed 401(k)/Roth 401(k). 401(k) plans are not subject to tax on UDFI generated by rental real estate. In order to move to a self directed 401(k)/Roth 401(k) plan, you must have a trade or business that can sustain the self directed 401(k) or self directed Roth 401(k).
If you roll from a Roth IRA to a self directed Roth 401(k), you solve your UDFI problem but you subject yourself to RMDs (and valuation issues) starting at age 73, reducing future tax free growth. You also added a requirement to file an annual Form 5500 tax return with the IRS if the self directed Roth 401(k) has $250,000 or more of assets. Another workaround is placing the real estate in the IRA/Roth IRA in a C corporation. This will lower the tax rate the UDFI is subject to down to 21 percent, but will also subject the non-UDFI income to that 21 percent tax rate.
Real Estate Losses
In some cases, depreciation combined with other deductions causes rental real estate to produce a loss for tax purposes. This can occur even if the property is “cash-flow positive” i.e., it produces cash income in excess of its cash expenses.
Why put an asset that generates a loss in a retirement account? Often times losses are suspended, meaning the rental property nets to zero on the tax return for that particular year. But the suspended loss is tracked and can be used in the future. Read this post for more information on deducting real estate losses.
Is the ability to use real estate losses from real estate held in taxable accounts limited? Absolutely. But it is fully eliminated if the real estate is in a retirement plan. Such losses can never be used on an individual’s tax returns.
Gilding the Lily
Discount brokerages have made this the best era to be a well diversified investor in equities and bonds. Costs associated with investing in index funds in retirement accounts are approaching zero.
This means equities and bonds reside in retirement accounts very well. Why do you need to gild the lily at that point? You have great investment options at a low cost.
To my mind, there is no compelling reason to reject this approach, particularly considering (1) depreciation and other tax advantages that help make rental real estate efficient in taxable accounts and (2) the burdens associated with housing real estate in retirement accounts.
Conclusion
In the vast majority of cases, if you want to own both financial assets (stocks/bonds/mutual funds/ETFs) and rental real estate as part of your portfolio, you are well advised to house your rental real estate in taxable accounts and save your retirement accounts for the financial assets.
It comes back to the tyranny of tactics. Real estate in an IRA sounds great, but when you peel back the onion, simplicity usually wins. Does this mean some with real estate in a retirement account will not achieve financial independence? Absolutely not. But the simpler path will keep your costs low and will likely be tax efficient.
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This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.