Is this deal too complicated for a newbie?

[Aaron Smith]

The newbie is me and I want to do three things in next twelve months and the first two are related.

I love my neighborhood, but meh about the house. It is halfway paid off and my wife and I would like to move for a myriad of reasons, but we both really like this neighborhood - not the house. I think we should refinance the equity out of this home, rent it out, and purchase the new construction with the funds. This would be our first rental and our goals is not cash flow, rather tax breaks.

Coincidentally, the new construction is in an urban area and we are thinking of building a 1/1 guest house primarily for family that we love, but can't live with. Maybe we will get some short term rental out of it, but it isn't really for that purpose.

Finally I am looking at a relatively new duplex near a military base golf course. For this I would use my self-directed IRA and set up a trust. Again, our goal is to lessen our tax burden and build up assets for retirement.

For those keeping score I want to (a) get equity from primary residence to fund new construction in fill (can I do this?) (b) rent the existing primary residence - home for the last 5 years and (c) use a IRA to fund a duplex right off base built in 2008.

I'm excited and nervous at same time.

Additional details about current home. Updated roof and kitchen in an older neighborhood. I think it needs about $20-30k in upgrades to make it sell, but probably half that for renting. I'm actually thinking about making it an lease option to buy.

[Jon Holdman]

You can't depreciate the rental over five years. The depreciation period for a rental property is 27.5 years. Period. You have no other choice. You can do componentization and depreciate some items, such as carpets or appliances, faster. But the bulk of the structure is on the 27.5 year schedule.

The "tax benefits" of real estate are largely limited to reducing the tax on rental income. Newbies are often told that a (crummy) rental will produce a passive loss and that they can then use use that to offset other income. That's true, but with a couple of big kickers.

One is that it is limited. Normally, passive losses cannot be used to offset ordinary income. However,there is a special allowance that allows up to $25,000 in passive losses per year to offset ordinary income if your AGI is under $100K. Doesn't matter if filing single or jointly, the AGI limit is the same. If your AGI is over $150K, this special allowance is $0. In between $100K and $150K it phases out, $1 reduction in the special allowance for every $2 of income over $100K.

Second is that you have to pay it back. When you sell, the amount of any gains up to the depreciation taken (or allowed, if you didn't take it) is subject to depreciation recapture tax. Keep in mind that the depreciation reduces the basis of the property and therefore increases the gain on the sale. Depreciation recapture tax is at your ordinary income tax rate, but is currently limited to a max of 25%.

So, there may be some tax benefits, but its very often less than newbies are led to believe.

If your IRA buys a property, then you don't need to bother with setting up a trust. Just set up an account with an SDIRA custodian, and have it buy the property. Any money that goes into the property must come out of the IRA and any profits must go back into the IRA. If you get debt financing on the property (difficult, but not impossible), then the rental income will be partially subject to UBIT - Unrelated Business Income Tax. If you convert to a Roth, I believe the UBIT will go away, and if your IRA owns it free and clear there is no UBIT on either the rental income or the sale.

Do read in the rental property forum about the reality of rental properties. Newbies very often underestimate expenses on rental properties and therefore overestimate the income. If your rent is less than double the P&I payment on your property, you'll be putting money or time into the property. This can be costly if you own the property directly, but it can be fatal for an IRA owned property. Because ALL funds put into a house owned by an IRA must be from the IRA, you cannot put any other cash into the property. If the house needs a new roof, and the IRA doesn't have the cash, you can end up being stuck. If you buy the roof, the money is considered a contribution to the IRA. That may be possible, but keep in mind the tax consequences.

If you move your current house into a trust, you will be the beneficiary of the trust. Money can come or go as you please. Not sure who's telling you the money stays in the trust, but I don't believe that's the case. In the IRA, yes. But just a trust? No. A trust is just a way to hide ownership, nothing more.

If your current home needs $20K in upgrades to sell, rest assured it will need more than that after a few years of renting.