Self directed IRA monies

[Mark DiPietro]

I am curious, if you use a self directed IRA in a BRRR strategy, when you refinance the house, can you take some of the proceeds out as cash; or, does it all have to stay in the IRA?

[Brian Eastman]

@Ned Carey & @Joe Arida

Unrelated debt financed applies in two ways; to the operating income of a debt-financed property, and on the gain at sale of the property if there is still debt-financing in place.

Ned's CPA is not entirely incorrect in his statement that the rate can be high, as IRA's are taxed at trust rates which scale to 36.5% at about $12,400 of income. These rates would apply to the net taxable operating income from a leveraged rental. The sale of property will be taxed at a lower 20% capital gains rate.

The key thing to understand, however, is that the net taxable income will generally be a small fraction of the gross income produced by a leveraged rental.

Here is a quick and dirty run of numbers.

$200K rental property purchase, using $100K IRA down payment and $100K non-recourse loan.

Rents for $2400 per month, or $28,800 per year.

Property is 50% debt financed, so 50% of the gross income ($14,400) is viewed as taxable.

You then reduce the gross taxable amount with a $1,000 exemption and then 50% of normal deductions including interest payments on the note, straight line depreciation on the property, operating expenses like property taxes, insurance, repairs, etc.

With operating expenses of about 30% of gross income, the net UDFI taxable income would be about $4,800 and the tax would be about $700.  That $700 is a small dent in your overall return, which is considerably boosted by the use of the borrowed funds.  

If a property is sold while there is still debt-financing in place, then the ratio of income attributable to the remaining financing is applied. Generally, the debt-financing ratio will decrease over time as the mortgage is paid down, so depending on when you sell, it could be considerably less than the initial 50% as in the above example. It gets difficult to illustrate that without running a 10-year proforma analysis or thereabouts, but again, the net result to the IRA is positive. Sure, you give up some of the gain on sale to taxation, but you are selling an asset with a valuation that is proportionally higher due to the use of borrowed funds. The cash-on-cash return to the IRA is still going to be a good number if it is a good deal.

This analysis is a bit high level (it is late on a Sunday evening), but hopefully illustrates the point that paying a little bit of taxes to benefit from leverage in an IRA is a net positive.

Far too many people here there is taxation inside of an IRA when debt-financing is used and turn the other way without doing a proper analysis. This is selling the potential of your IRA short.