[u]Just found this... more confused now.
Are the gains or income taxable from IRA real estate investments?
This is a frequently asked question. The answer is NO - in most cases.
If an IRA buys investment real estate and then sells it at a profit, all income generated while it was held in the IRA and all the gains resulting from sale WILL be either tax-deferred (regular IRA) or possibly tax-free (Roth IRA), IF the purchases were all cash with IRA funds.
If the IRA borrows to finance the purchases, any income and capital gain that is attributable to debt-financing will be subject to taxation. So, for example, if an IRA puts 50% down on a rental property and that property generates $10,000 net income after expenses per year, the IRA will be taxed on 50% of the net income (the amount financed) less the first $1,000 which is tax exempt, or $4,000 (e.g., 50% x $10,000 = $5,000, less the $1,000 exemption = $4,000). The tax is charged at the Trust tax rate schedule because an IRA is considered a Trust for the purpose of tax. The tax applied is called Unrelated Debt Financed Income tax or UDFI tax.
Similarly, when the property is sold, the IRA will have to pay capital gains tax on any gain that was debt-financed. For example, if the same property was sold two years after purchase for a $100,000 profit, 50% (assuming there had not been any reduction in the debt) of the gain, or $50,000, would be subject to tax at a rate of 15% (the current long term capital gain rate). This results in a tax of $7,500. The remaining $92,500 would go back to the IRA tax-deferred. The IRA would also have to pay UDFI tax on any income on the property in the year of sale. Finally, if the debt had been reduced through principal payments on the loan, then the amount of UDFI and capital gains tax would be calculated based on the average indebtedness over the twelve months prior to the sale. If all the debt had been paid off one year prior to the sale, there would be no capital gains or UDFI at the time of sale.
Are you saying that if I buy income-producing or other real estate using all cash and sell it for profit, that I never pay any tax?
No. If you buy real estate, stocks, mutual funds, etc. with a traditional IRA, without incurring debt to the IRA, all the profit and income flows through to the IRA tax-DEFERRED. You can buy and sell property for twenty years or more in an IRA without paying either capital gains or income tax, provided that the investments are not debt-financed. If some or all of the investments are debt-financed you will pay UDFI tax on the amount of income and capital gains that were generated using debt. But assuming, for simplicity's sake, that you buy 100 acres in Wyoming with cash and sell it 10 years later for a $400,000 gain after the [b]debt has been retired for at least twelve months, all of the proceeds would go back into the IRA tax deferred for the next investment.
You can continue to do this until you either voluntarily decide to take withdrawals from your IRA (penalty-free after age 59 ½), or until you are required to at age 70 ½. Once you begin to withdraw funds or assets from your IRA, you are taxed at current ordinary income tax rates on the fair market value of what you withdraw. If you withdraw $25,000 in cash, you have to add $25,000 to your taxable income as reported on your 1040 in the year of the withdrawal. If you withdraw 100 acres in Wyoming in one distribution (as opposed to fractionalizing the distribution over a number of years to reduce the one-time tax hit), you will have to have the property appraised and the value will be reported by the custodian as a taxable distribution on your 1099.
