SDIRA vs After Tax Cash

Tax, SDIRAs & Cost Segregation
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SDIRA vs After Tax Cash

Nathan Emmert
Investor · San Ramon, CA · Member since 2011 · 1k+ posts · 569 votes

I'm curious if anyone has run a comparison of the returns on a Self Directed IRA versus simply using after tax cash.

So funding a SDIRA has an obvious benefit, tax savings. With all the deductions and credits, etc etc etc, lets assume our real tax rate is 20%. I can fund $10,000 (for a couple) into 2 SDIRA accounts or fund $0 and have $8,000 cash after taxes.

From an investment point of view, I can take that SDIRA and buy real estate... but I must buy with a non-recourse mortgage. That means I need 40 - 50% down and will be paying 6.5 - 7% interest. On a $200k property, that's a $90,000 downpayment and $695 monthly payment.

With Cash, I can get in at 25% down and get SFH (4plex) at 5% interest. That'd be $50,000 down and a $805 payment.

The extra $40,000 cash only returns $1,320 a year (cash on cash) which is 3.3%... pretty crumby. Sure, I save taxes again on the cash return but with depreciating of the unit, most of that "profit" is wiped away in taxes anyhow.

Just curious what people think... is it worth funding a SDIRA for real estate investment or better just leaving the money in your checking account and taking the hit? Obviously if you're rolling over a 401k that had company matching or something the numbers change some... this is simply would you put $10k a year in an SDIRA or simply real estate invest with cash?

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Steven Hamilton IIPro Member
Accountant, Enrolled Agent · Grayslake, IL · Member since 2011 · 5k+ posts · 2k+ votes
14y
Originally posted by Nathan Emmert:
Good point Andy... buying a property in cash with your SDIRA... but part of that would also depend on your risk tolerance... given 5% interest rates, would you rather buy 1 property in cash or put 25% down on 4 properties? Long term, I think you'd be better off in the 2nd scenario though obviously it's a more leveraged and therefore a more risky position. Granted, if you already have 10 mortgages, things skew a bit... but there's always creative financing and other ways to get beyond that limit too.

I'm sort of stuck in between... we have money in an old 401k from past employers... we can either just withdraw it and take a 20% tax hit... or roll it into an SDIRA. Given the amount, rolling it into an SDIRA doesn't seem to give us much bang for the buck due to the non-recourse lending standards so we'll probably just take the 20% hit and go on our merry way.

Nathan, It is not necessarily just a 20% hit. If you and your wife are in the 25% bracket without any withdrawals, you'll be taxing this income at that rate and possibly higher. Then you will also have an additional 10% early withdrawal penalty. That's 35% not just 20%. If you want to just pay the taxes on it and avoid the 10% penalty. You could consider a Self directed ROTH IRA.

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  • Bryan Hancock
    Investor · Round Rock, TX · Member since 2010 · 8k+ posts · 4k+ votes
    14y

    Good question. I haven’t done the math, but you certainly don’t have a free lunch in the scenario you are describing.

    Keep in mind that there are other ways to invest in real estate that do not involve non-recourse debt. If you invest in LLC units of another opportunity the issues you wrote about go away. My suspicion is that there isn't much benefit of investing in rental property on your own if the debt constant spreads are as big as you say they are. However, if a fund or some other party signed for the debt and you simply invested equity in their entity you wouldn't necessarily have the pricey debt.

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  • Jon Holdman
    Rental Property Investor · Mercer Island, WA · Member since 2008 · 22k+ posts · 14k+ votes
    14y

    There will also be UBIT in the scenario you describe.

    I've ran these numbers numerous times and came to the conclusion that between the difficulties of getting loans, the risk of not having enough money in the IRA to deal with a bad situation, and the UBIT taxes, that owning financed rental property in an IRA is not a good idea. In general, I think owning un-financing rentals doesn't produce as high of returns as using financing.

    There is a third alternative, though. A Roth IRA. Its my understanding that avoids all taxes, including UBIT.

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  • Nathan Emmert
    OP
    Investor · San Ramon, CA · Member since 2011 · 1k+ posts · 569 votes
    14y

    Jon, as for UBIT... I was told it would only apply if you essentially run a business out of your SDIRA, i.e. flip several properties a year. In a buy and hold investment strategy, it didn't apply.

    Granted, this was from a sales guy and not legally binding advice so that may be wrong, simply what I was told...

    Bryan, can you tell me more? I'm not sure how things go away in the scenario you described. If I can do something useful in an SDIRA I will definitely be throwing some money there versus more stuck in bad investments in my 401k next year. Please explain.

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  • Andy M.
    Investor · Farmington, UT · Member since 2011 · 314 posts · 179 votes
    14y

    Nathan, I think UBIT still applies, even in a Roth. I currently have a SD Roth and I almost bought an owner financed deal with it. The seller was willing to carry the whole thing non recourse with a 10% down payment but according to my administrator it would have been subject to UBIT. I ended up doing the deal anyway just not inside my roth. Unless you can pay for the whole property, or a large amount with you IRA it doesn't seem worth it. Currently I use my IRA and my wife's as participants in HML's. This creates a good return and allows the account to grow. I also plan on wholesaling with my IRA to grow it quickly (optioning property with IRA and selling the option to end buyers, option route gets away from UBIT).

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  • Nathan Emmert
    OP
    Investor · San Ramon, CA · Member since 2011 · 1k+ posts · 569 votes
    14y

    Good point Andy... buying a property in cash with your SDIRA... but part of that would also depend on your risk tolerance... given 5% interest rates, would you rather buy 1 property in cash or put 25% down on 4 properties? Long term, I think you'd be better off in the 2nd scenario though obviously it's a more leveraged and therefore a more risky position. Granted, if you already have 10 mortgages, things skew a bit... but there's always creative financing and other ways to get beyond that limit too.

    I'm sort of stuck in between... we have money in an old 401k from past employers... we can either just withdraw it and take a 20% tax hit... or roll it into an SDIRA. Given the amount, rolling it into an SDIRA doesn't seem to give us much bang for the buck due to the non-recourse lending standards so we'll probably just take the 20% hit and go on our merry way.

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  • Dennis Tierney
    Investor · Omaha, NE · Member since 2011 · 475 posts · 211 votes
    14y

    I have invested in apartments through a SDIRA and have not yet run into the UBIT issue due to the ability to depreciate the building leading to no profit for the IRA. I did it to be able to produce good cash flow in the retirement account and not have the risk of it being cut in half as it could be in the stock market. I did it as a rollover from a 401k and so far it has worked well for me. The issue is the nonrecourse loan but I have been able to find a mortgage broker that has been able to get me 70% LTV via an insurance company. They are expensive with a lot of closing costs but I have been able to get 10 yr loans (20yr amo.) at 5.5% rates. Good luck.

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  • Jon Holdman
    Rental Property Investor · Mercer Island, WA · Member since 2008 · 22k+ posts · 14k+ votes
    14y

    Fundamentally, UBIT applies to ALL businesses you run out of your IRA, including rentals, loans, fix and flips, etc. Then, there are a number of exemptions. Those include passive actives like making loans and rentals. Then there are exceptions to the exceptions. A key one of these is UDFI - unrelated business debt financed income. So, which income from a rental is exempted from UBIT, the debt financed portion is subject to UBIT.

    I believe wholesaling, regardless of how it is structured, is going to be subject to UBIT. If you're creating options then selling them, they're "inventory" and its an active business. Fix and flipping would be an active business, too.

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  • Dennis Tierney
    Investor · Omaha, NE · Member since 2011 · 475 posts · 211 votes
    14y

    Jon - Mine is UDIF as I invest only passively as a long term hold and have professional 3rd party companies do the management.

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  • Don Hines
    Investor · Little Rock, AR · Member since 2010 · 628 posts · 251 votes
    14y

    I hope I don't hijack this thread. but, it is much along the lines of how my wife and I are thinking. I have a couple of what I call personal IRAs. Those and my 401k have lost about 25% in the last quarter. We are thinking about using them and taking the hit on the taxes and penalties and eliminating our mortgage. We still have 25 years left on it and the intrest more than offsets the hit on the IRA penalties. I could wait another 4 years and not have the early with drawal penalty. But, again, I would pay more in intrest in that period than what the penalty is. At the rate my investments are reducing, I am kind of getting panicked to do something else with them. Ain't enough left to retire on anywho.
    Don

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  • Jon Holdman
    Rental Property Investor · Mercer Island, WA · Member since 2008 · 22k+ posts · 14k+ votes
    14y

    Not quite sure what you mean by that, Dennis: "Mine is UDIF as I invest only passively as a long term hold and have professional 3rd party companies do the management." Since you have debt on the property, you are subject to UDFI on the debt financed fraction. All the usual deductions, including depreciation, do apply, though. So, as for many leveraged rental properties, the actual taxable income is low vs. the cash flow.

    However, that does create a problem. The "debt financed fraction" is the amount of debt divided by the basis. As the property depreciates, the basis goes down by the greater of the depreciation actual taken or allowed. That goes down by 1/27.5th of the value of the improvements each year. Yet, your loan probably doesn't pay down the debt by that much in the early years. This means that "debt financed fraction" actually increases over time, at least during the early years of the mortgage. When I set up my IRA with Guidant some years ago, I discussed this specific point with the attorney and he researched this topic and agreed this does actually happen.

    Nevertheless, its entirely possible that the taxable income on the property is low enough that the UDFI is zero or low.

    I'm going to have to do some more research on the Roth question. Don't have a Roth at the moment, but I've thought about converting to that because that, as I understand, full avoids the taxes.

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  • Bryan Hancock
    Investor · Round Rock, TX · Member since 2010 · 8k+ posts · 4k+ votes
    14y
    Originally posted by Nathan Emmert:
    Bryan, can you tell me more? I'm not sure how things go away in the scenario you described. If I can do something useful in an SDIRA I will definitely be throwing some money there versus more stuck in bad investments in my 401k next year. Please explain.

    If you buy equity shares in another company AND things are structured correctly you won’t have to pay UBIT or UDFI. I have a lot of email threads and literature about this. I have also paid for advice about it from one of the largest accounting firms in the country. I have posted some of this information before, but it is always taken down because it is deemed promotional. If you PM me I’m happy to send you what I have.

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  • Will BarnardPro Member
    Moderator
    Developer · Santa Clarita, CA · Member since 2008 · 15k+ posts · 10k+ votes
    14y

    Lets get a few things straight here as it appears there are some misunderstandings. When Jon first mentioned UBIT regarding the rental property, he was refering to the fact that debt leverage was intended to be used which UDFI triggers the UBIT. A buy and hold rental inside yoru IRA is exempt from UBIT UNTIL you use debt leverage. Now, if you pay off your loan with IRA funds and keep the property for at least 1 year, then the UBIT is washed away (another exemption option)

    For active business models like wholesaling, flipping, etc. IRA's are subject to UBIT as it levels the playing field with non tax deferred entities.

    A ROTH IRA is exempt from UBIT because taxes have already been paid so that too levels the playing field.

    Personally, I believe that buy and hold RE held in an IRA is a poor use of those funds. I would suggest using those funds to make loans. You can earn double digit passive returns without any management headaches, broken toilets, excess resrves needed, etc. and no UBIT.

    @Don - Before you make such a decision, consider this: If you ask the IRS for permission, and show evidence that only your IRA is the benefactor of the structure, you may be granted permission to have your IRA be the lender for your personal residence. Here is what you do: Show your current mortgage rate, show 2-3 quotes of current mortgage rates, then use your IRA to lend at thjose market rates to pay off your mortgage. Now, you personally will pay yoru IRA the monthly mortgage and your IRA will now grow at that rate (todays market rate is around 4%). So, if you are happy with stopping the beeding from your IRA and have it only gain 4% each year, then that would be a better option than paying all the taxes, plus early withdrawal penalty.

    Secondly, why are you still having your IRA invested in things that are losing 25% annually? Why not invest it in notes and start earning 10%+?

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  • Patrick McNeill
    Real Estate Investor · Willoughby, OH · Member since 2009 · 11 posts · 0 votes
    14y

    Jon and Will, you have both stated in this thread that holding rentals in your SDIRA is not ideal because it does not produce high enough returns. I have been looking into doing just this, and I think many people on this site are. So I was hoping you could look at this scenario and let me know what you think.

    You open an SDIRA and fund it with 45k.
    You purchase a property for 40k.
    Using the 50% and 2% rule, your profit is $400/mo, or $4800/yr.
    Let’s say you spend $500/yr on custodial fees.
    You have now profited $4300/yr on $40k investment. 10.75% return.

    Am I missing something? I know these aren’t phenomenal returns but still must better than the market for the past 10 years.

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  • Nathan Emmert
    OP
    Investor · San Ramon, CA · Member since 2011 · 1k+ posts · 569 votes
    14y

    Patty... you could always liquidate your SDIRA, take the 20% hit, and have $36k in cash.

    From there, you buy a $144k worth of property(s) with your $36k down (25%).

    Assuming 50% and 2% you're pulling in $2,900 in rents, clearing $1,450. Assuming you have strong credit, you're getting 30 years financing at 5% on the $108k you mortgaged and are paying $580 a month towards your debt leaving you with $870 a month in free cash flow.

    Based on your $45k, you're now getting $10,440 a year in returns, or 23.2%.

    It is easy to get "good" returns like 8 - 10% fairly low risk. Most of the "investors" here are looking for better than that.

    Big issues with SDIRAs are two fold. Being tax advantaged they double dip the depreciation deduction so many investors like. Investors can make $5,000 free cash flow and deduct $5,000 of depreciation in the property. They get cash in their pockets and don't pay Uncle Sam. With the SDIRA, they wouldn't have paid Uncle Sam anyhow.

    The second issue is the requirement to do non-resource loans. To maximize your returns you need to be leveraged. Because the loans are non-resource you'll put anywhere from 35 - 50% down (vs. 25%) and you'll pay 6.5 - 7% (vs 5%).

    Just some things to think about. Generally if your employer does matching on contributions, it's sort of a no brainer, but at some point, all these tax advantaged programs really need to be evaluated to see if they are your best alternative.

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  • Patrick McNeill
    Real Estate Investor · Willoughby, OH · Member since 2009 · 11 posts · 0 votes
    14y

    Nathan, I have actually thought of doing that and it does make sense mathematically. But there are other issues which I’ll explain.

    First, if I were to liquidate, after all write offs and everything, I’d have to pay the 10% penalty plus about 25% in federal taxes. So that’s 35%. And then there are state taxes which would be about 4-5%.

    So let’s say I get 60% back. That’s $27k. $108 in property.
    50 and 2 gives $2160, clearing $1080. 30 years 5% is $435/mo.
    Cash flow is $645. $7740/yr. 17.2%.

    Yes this 17% sounds great but these are all theoretical numbers. Getting 5% on a non-owner-occ is pretty hard to find. And I already have 3 rentals with mortgages. So I’m not sure what the limit is at this point, it has been only 4 in the past.
    Plus you have to count in PMI and loan fees. I think that $435 is gonna end up being closer to $600. Which would bring us down to the 13-14%.

    To me, it just seems that not even dealing with banks at this point is so much easier. It’s easier to bid on properties when you have cash. People seem to accept a lower offer when it is cash.
    Now, I’m assuming that this SDIRA will be the same as cash when I go to make a bid.

    I understand that leverage is a huge advantage, but once you can’t get loans anymore, SDIRA’s seem like a great way to buy rentals.

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  • Steven Hamilton IIPro Member
    Accountant, Enrolled Agent · Grayslake, IL · Member since 2011 · 5k+ posts · 2k+ votes
    14y
    Originally posted by Nathan Emmert:
    Good point Andy... buying a property in cash with your SDIRA... but part of that would also depend on your risk tolerance... given 5% interest rates, would you rather buy 1 property in cash or put 25% down on 4 properties? Long term, I think you'd be better off in the 2nd scenario though obviously it's a more leveraged and therefore a more risky position. Granted, if you already have 10 mortgages, things skew a bit... but there's always creative financing and other ways to get beyond that limit too.

    I'm sort of stuck in between... we have money in an old 401k from past employers... we can either just withdraw it and take a 20% tax hit... or roll it into an SDIRA. Given the amount, rolling it into an SDIRA doesn't seem to give us much bang for the buck due to the non-recourse lending standards so we'll probably just take the 20% hit and go on our merry way.

    Nathan, It is not necessarily just a 20% hit. If you and your wife are in the 25% bracket without any withdrawals, you'll be taxing this income at that rate and possibly higher. Then you will also have an additional 10% early withdrawal penalty. That's 35% not just 20%. If you want to just pay the taxes on it and avoid the 10% penalty. You could consider a Self directed ROTH IRA.

    [email protected]224-381-2660
    1Reply
  • Will BarnardPro Member
    Moderator
    Developer · Santa Clarita, CA · Member since 2008 · 15k+ posts · 10k+ votes
    14y

    Patty,
    Let me jump in here since your question was asked of me. I would ONLY recommend Nathan's suggestion in extreme circumstances, he did not factor in the taxable amounts on the 20%+ return in the projected scenario either.

    here is why I believe the returns are low for the risk and headaches in an IRA for buy and hold: You lose the depreciation deduction because the IRA is already tax deferred; you must make sure that you have excess funds sitting in the IRA and held by your TPA earning 0% interest (you need these funds in case unexpected expenses arise; you have a part time job for your IRA that can not pay you anything for your time and effort; you have to be so very careful as to not do anything that could be construed as a prohibited investment; and finally, a 10% or even 15% return in an IRA for having such risk and a managerial headache is not worth it in my book.

    I suggest you make that very same 10% (or more) making loans to rehab flippers at low LTV's and get the same or better returns without any managerial headaches and if you do it right, with no risk. You can also do many other types of investments in RE that do not have the buy and hold headaches and make passive double digit returns for your IRA that grow tax deferred!

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  • Patrick McNeill
    Real Estate Investor · Willoughby, OH · Member since 2009 · 11 posts · 0 votes
    14y

    Thanks Will for the response and advice. If I knew some other flippers that were reliable, that would be a good option. But I don't, and really don't think that those would be considered "no risk."
    I’m sure there are better ways to use an SDIRA than buy and hold, but I’m just trying to stick with what I know.

    Sorry Nathan, didn't mean to hijack your thread. So I'll try to give a little better response to your original question.
    If you have an existing IRA, I'd say don't cash it out and take those huge penalties. Turn it into an SDIRA and invest with that.
    If you are using your own money, invest with cash. That way you can reap all the benefits: depreciation, write-offs, etc.

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  • Will BarnardPro Member
    Moderator
    Developer · Santa Clarita, CA · Member since 2008 · 15k+ posts · 10k+ votes
    14y

    Patty, the no risk comment comes from investing with seasoned pros who have a track record and from ONLY making loans on deals that are very low LTV's such as 50%. The worst case in such scenarios becomes your best case in that if they fail to perform, you foreclose, take the property back, finish the rehab and re-sell yourself inside the IRA and likely make more than just the interest you would have made on the loan - even after you factor in time and foreclosure costs. That is why I stated the "no risk comment"

    Back on topic, I agree that liquidating your IRA nad taking the tax and penalty hit is not a wise move. Not only do you take the hit and essentially get double taxed (tax on liquidation and tax on profits of cash used outside of IRA) you lose your ability to grow your IRA tax deferred which is one of the largest benefits of having one.

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