Question about tax free earnings with SDIRAs

[Christine Oliphant]

I've been learning about SDIRAs and from what I understand when you use the money in your real estate business, the money you earn will be tax free. So as Amanda Han put it in podcast 49, if a wholesaler puts a $1,000 earnest money deposit down and then makes $10K from the deal, those earnings are tax free.

Does this also apply when you fix and flip a property? So if you buy a property for $50K and end up with $30K in profit, those earnings are not taxed?

It doesn't seem like that could be the case since people are doing 1031 exchanges but I'm just trying to figure out the best avenue to save on taxes for fix and flip deals.

Am I understanding this correctly?

[Peter K.]

Hi Christine,

I'll start off with the disclaimer that I am not tax professional and don't play one on HULU...however, I have a self-directed IRA and have done several different RE investments with it.

First, as you probably already know there are two types of SD IRAs:

1. SD IRA. Pre-Tax deposits into this account are Tax-Deferred. Once you reach a certain age...59 1/2 I believe, you can begin withdrawing money from this account without penalty, while paying taxes on the money at that time based on your tax bracket at that time. In your examples, any profits would continue to grow this account without tax consequences....until you begin withdrawing the money.

2. SD Roth IRA - After-Tax deposits into this account grow tax-free. The idea is that you've already paid the taxes on the seed money, you shouldn't pay it again on the growth. This is a great choice if you A) expect to be in a high tax bracket in retirement (great problem to have) or B) expect huge growth/returns on your investments (another great scenario). Basically, it's the optimists IRA. :-)

An SD IRA can be converted to a Roth. The downside is that a big chunk goes to Uncle Sam and Aunt Samantha now. Some things to consider before converting:

1. What will the expected investment amount be per transaction?...meaning, if you are going to be fixing flipping 500K homes, you'll need at least that amount and some reserves in your account. So if you have 600K now, you may want to wait before converting to a Roth, as you may end up with insufficient funds to do a transaction.

2. If the amount is not an issue, you may want to consider having a smaller Roth account for the $1K to $10K example that you gave above.

There are many more things to consider, but these are some of the basics. Hopefully, it helped. Many of the SD IRA administrators, like Pensco have free trainings that cover more details. And by all means make sure that your accountant chimes in and gives you their blessing before making a decision.

Last thing is that it sounds like your main goal is to avoid paying high taxes on Flips....join the Club! :-) Flipping can be flipping expensive when it comes to taxes. Make sure to keep good records so that you are writing off all of the allowable business related expenses. Even meals and entertainment with business partners and clients are potentially a tax write-off if you discuss business...see disclaimer above. Some investors do flips to build the war chest then use some of that money to buy and hold for income that is not so flipping expensive.

Do a web search for Sandy Botkin. He is a CPA, tax lawyer and ex-trainer to the IRS lawyers. I got a lot out of his training program. It gives amazing ideas on how to legally maximize business expenses while easily documenting them to audit-proof your return.

Good luck! Happy investing!

Peter