Hi Eric, welcome to BP. As evidenced, there is a lot to consider. I'm also looking to invest a portion of my IRA funds in real estate and, based on my research, below are some clarifying points.
1. What is taxed? Keep in mind, the only part of net income that is taxable is the portion financed. If you finance 50% of the property (with a non-recourse loan), then 50% of the NET profit is taxed after you deduct all expenses and, yes, depreciation from the portion you financed. True, you can't take depreciation for IRA funds used, but you can realize depreciation on the portion financed - which reduces the income subject to taxation. Also, as Brian notes, the tax is pretty low. It's based on the Trust Tax Schedule (which for 2018, looks to be 10% for net income $0-$2500; then 24% between $2501-$9150 etc.) Example: If your property grosses $10,000 and after all deductions (taxes, insurance, repairs, expenses, depreciation) you end up with a net income of $2500, the Unrelated Debt Financed Income (UDFI) portion is 50% or $1250 -- so the tax would be $120.
2. No depreciation in an IRA? True for your IRA funded portion only. For the IRA money used, I grappled with this a bit, but in thinking it through, who cares? We like depreciation because it provides an offset to our taxable income -- so we pay less taxes (assuming your income isn't too high in which case losses are deferred). But if you're in an IRA, all the income made from real estate goes back into the IRA -- so I don't think we lose anything. I'm not paying taxes on any income the IRA generates, so who cares if we can't depreciate? Also even in non-IRA scenarios, we make up the depreciation on the other end (it gets added to cost basis). Playing it out, we retire, start taking distributions from the IRA, the property is paid off (or not), and all the income that's been accumulating over the years is sitting there -- still accumulating from rents coming in. Depending on whether it's a Roth or Traditional IRA, you pay taxes on withdrawals, but you would do this regardless of the IRA investment vehicle.
I love this because unlike the commercials that scare you with asking how long your money will last into retirement, with real estate you have a living entity that generates income as you take it out. So live to 100 and not worry! Of course good dividend stocks can also provide income, so good to diversify. I agree with Brian's point that it boils down to where you want to invest your retirement savings.
I'm still learning, but it helped to write this out. I hope it was of some use. There are some great resources here - https://www.trustetc.com/self-directed-ira/rules/ubit
