In our conversations with real estate investors, from our seminars, webinars and conference presentations to the one-to-one chats investors have every day with our counselors, one theme that keeps coming up is taxes.
We’re not surprised: who doesn’t want to make sure their retirement portfolio minimizes their tax exposure? What we do find surprising is that so many real estate investors choose to invest through a single-member LLC instead of a self-directed IRA and do so because of their understanding of the tax landscape.
What if strategic investing decisions through a self-directed IRA weren’t just preferential for potential tax advantages, but could also result in stronger returns and more opportunities for additional property investments?
Let’s take a closer look at the two.
For many real estate investors, the default option is to incorporate a single-member LLC, because they want to avoid UBIT, or Unrelated Business Income Tax. UBIT was instituted to ‘level the playing field,’ utilizing a phrase from University of Pennsylvania Carey Law School Professor Michael Knoll’s landmark paper on the subject published in 2007.
Income into a self-directed IRA resulting from real estate is subject to UBIT. Income into a single-member LLC is not. It is instead counted on Schedule E on a 1040.
On the face of it, going with an LLC seems like the right move – Again, who wants to pay more in taxes, especially out of their retirement? But that’s only looking at the situation on the surface.
UBIT is only applicable to the amount of the real estate investment purchased with debt and is at the corporate tax rate rather than individual. There is also a potential $1,000 deduction that can be triggered for many IRA-based investors.
That’s a lot of information, but it doesn’t answer the question. Is an LLC the right approach to investing for retirement?
Let’s run the numbers below and see where the real value lies.
Death and taxes: the two unavoidable realities we all face. And when we put our money to work for us through investing, we want to do so in ways that minimize our tax liability. (Sorry, we can’t help you with the other thing.)
In part one above, we explored the tax landscape for both a selfdirected IRA and a single-member LLC, BIT versus taxes assessed through Schedule E. But let’s run a scenario and some numbers to see the difference more clearly.
$150,000
$150,000
$75,000
$75,000
$12,000
$12,000
$5,000
$5,000
$7,000
$7,000
| SDIRA Sam | SMLLC Steve | |
|---|---|---|
| Purchase Price | $150,000 | $150,000 |
| Loan Amount | $75,000 | $75,000 |
| Rental Income | $12,000 | $12,000 |
| Operating Expenses* | $5,000 | $5,000 |
| Net Income | $7,000 | $7,000 |
Steve’s income is taxed at the individual income tax rate. Assuming $120,000 in a tax year, that is 24%, or $1,680.
The self-directed IRA is subject to UBIT, but UBIT only applies to 50% of net income, because 50% of the investment was financed and there is an available $1,000 tax deduction for qualified filers. UBIT is also taxed at 10%, the Trust & Estates Tax Rate ( Assuming investment is held for the short term), meaning the self directed IRA holder’s tax liability is only $250, while the remaining $6,750 is either tax deferred or tax-free outright.
To recap, there are immediate tax savings now, potential tax advantages in the future and the further ability to mitigate tax exposure all through investing through your self-directed IRA. None of this is possible through an LLC.
The Advantage Is Clear: A Self-Directed IRA Can Put More Money in Investors’ Portfolios.
10% of taxable income
$310 + 24% of the amount over $3,100
$2,242 + 35% of the amount over $11,150
$3,659.50 +37% of the amount over $15,200
| If Taxable Income Is: | The Tax Due Is: |
|---|---|
| $0 - $3,100 | 10% of taxable income |
| $3,101 - $11,150 | $310 + 24% of the amount over $3,100 |
| $11,151 - $15,200 | $2,242 + 35% of the amount over $11,150 |
| $15,201+ | $3,659.50 +37% of the amount over $15,200 |
Actually, getting started toward growth is not only possible, but easier than you may think. We’ll show you how you can be SDIRA Sam below.
As we’ve explored above, the power of a self-directed IRA lowers your immediate tax exposure while providing you potential long-term tax advantages. We’ve run through a hypothetical transaction with SDIRA Sam and SMLLC Steve showing how the numbers add up.
Now, we’ll show you how you can get started regardless of how many commas live on your IRA portfolio.
Many investors and lenders steer clear of fractional ownership and non-recourse lending because they can be complicated processes for those who don’t have experience and expertise with them. In short, fractional ownership is a transaction using a percentage of retirement funds as part of the purchase, with the remaining amount financed through a non-recourse loan.
A non-recourse loan is secured exclusively by the loan’s collateral, with the only option in the case of default being to repossess the collateral. This is what makes real estate investing within a self-directed IRA possible.
Admittedly, it’s a lot to process, and this is where having an expert advocate team can help you navigate these transactions with peace of mind and full compliance with all regulations. The seasoned team at IRA Power Loans is always here to help!
Let’s look at another scenario.
The maximum amount you can contribute to your IRA is $7,000 per year: Starting at that amount on a $100,000 real estate investment, using a non-recourse IRA Power Loan to fund the rest of the investment allows you to start with one investment property and slowly build momentum, or it can free up other capital in your IRA to make additional investments (in real estate, or nearly anything else that can have investors) to diversify and hedge against risk.
Income generated from the cash portion of these investment properties enjoys tax advantages and can exponentially increase your IRA’s value. While income on the portion secured by the non-recourse loan is subject to Unrelated Debt-Financed Income (UDFI), similar to UBIT, it is still taxed at the lower corporate rate and may have a $1,000 deductible, as mentioned earlier in Part 1 and demonstrated in Part 2.
Investors using a single-member LLC have to manage all of this on their own Schedule E, likely at higher tax rates and in higher brackets, meaning less money to work with to meet their investment goals. The advantage is with the savvy investor using a self-directed IRA and non-recourse lending.
With intelligent planning and prudent decision-making, the combination of a self-directed IRA and leveraging the power of fractional ownership can result in strong investment returns and growth, seeing financial goals reached faster, and allowing you to dream bigger for your retirement and your family’s legacy.
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