Theory vs. Reality: Why IRA Investors Could Care Less About Loss of Depreciation Write-Offs

The internet is a great thing.  Safeguard Advisors would not exist without the ability to market our very specialty services surrounding self-directed IRA and Solo 401(k) plans to a national audience.  Even in a big city like Los Angeles or New York, we could not run a business based solely on self-directed retirement plans if we could only serve investors able to stop by our office.

Well, sometimes the internet also stinks.  There is just too much information, not all of which is worth the bits used to store it.  And that can be confusing.

A case in point is the very adult sounding argument; “Why would I invest my tax-sheltered IRA in an asset like real estate that already has so many tax benefits?”

We see that on the internet… a lot.

Well, let’s think about that a bit.

Tax Advantages of Real Estate Investing

It is no secret that real estate is one of the most tax-favored investments around.

When you invest in real estate such as rental properties, a wide array of deductions become available, including mortgage interest and operating expenses like property taxes and repairs.

Depreciation of real property produces significant tax write offs, especially if you can take advantage of accelerated deprecation with tools like cost segregation.

It is quite possible to have positive cash flow from a rental property and not owe any taxes.

When you sell a property held for more than a year, the income is treated as capital gains, and taxed at lower rate than regular income.

If you utilize a 1031 exchange when selling a property, and re-invest the gains into another property, you can kick the capital gain down the road and avoid taxes for years until you actually just sell and keep the cash.  Or, you might die and leave the capital gain to your heirs, but they will only be taxed on the gain from the inherited basis.

If you are a real estate professional who has active involvement in property investing, there are a host of other deductions that become available.

Tax Treatment of IRA Property Investments

When an IRA or 401(k) retirement plan invests in rental property, all of the tax benefits listed above disappear.

An IRA is not taxed on rental income or the gain on sale of a property.

Well, when you don’t have taxable income, you don’t get to take advantage of tax deductions.

At the surface, that all sound good, but what about the exit strategy?

The downside of a tax-deferred IRA is that when you do eventually call in your chips and take a distribution, you pay taxes at regular income rates.

To a tax theory purist, you just took income with a potential for a low tax rate and moved it to a higher tax rate.  That sure sounds like a bad idea, doesn’t it?

The Argument Against Real Estate in an IRA

So, let’s go back to where we started: the internet.

A lot of people with credentials like CPA or CFP – or even just folks who have been smart and fortunate enough to accumulate a big bank account – claim that it makes no sense to put a depreciable asset in a tax-sheltered retirement plan.

Why eventually pay regular, earned income tax rates on IRA withdrawals from property investing when a non-IRA investment can be taxed at lower rates?

When you ask the question that way, it does kind of seem counterproductive to invest an IRA or 401(k) in real estate.

But, are you really asking the right question?

We say no.

Apples and Oranges

What tax rate do you pay when you take a distribution from an IRA that has been invested in the stock market?

You pay normal income rates.

So, any distribution from an IRA is taxed at normal income rates, regardless of what type of investment the IRA participated in.

It is pretty simple, but it is a fact that is entirely overlooked by the “why invest an IRA in real estate?” crowd.

The tax treatment of an IRA is just different than the tax treatment afforded to non-IRA capital.

With a tax-deferred IRA, you start with pre-tax money.  That means you get more cash to start with than if you paid taxes and put the money in your personal account.

When you invest that IRA money, the income is not taxed.  You can then reinvest 100% of the income without a loss to taxation.  Compounding that tax savings over a lifetime allows you to accumulate a much larger nest egg than if you had first paid taxes on the original contribution and then paid taxes each year on the investment income.

Yes, you will likely pay more in taxes when you do take distributions, but paying more taxes if you still receive more net spendable after-tax cash in your pocket is still a win.  That is why an IRA makes sense.

If we go back to real estate in an IRA, then we have to question; are we even asking the right question?  The answer is usually no.

Comparing a hypothetical real estate investment made in an IRA to a similar real estate investment made personally… well, that is just apples and oranges.

Asking the Right Question

Comparing any investment made with an IRA to an investment made personally is not really meaningful.  The tax treatment is just plain different regardless of the asset type.

The comparison that we think makes a lot more sense is this:

“How does investing my IRA in real estate compare to what my IRA is invested in today?”

Now we have an apple in both hands.  Maybe a pair of nice, fresh, Cosmic Crisps if we are lucky.

For someone who knows how to make money in real estate already, the rest of the conversation is easy.

“Can my IRA investment in real estate provide better principal security, higher income, and more pathways to income than sending my IRA dollars to Wall Street and crossing my fingers?”

“Can I have more control over investment selection and the asset lifecycle putting my IRA in real estate?”

“If I invest $100K of my IRA in real estate today and turn that into $400K or more in the next 10 years, will I be sad that I did not get to take write-offs for depreciation along the way?

Or, Just use a Roth IRA

If you want to win all around, make taxation a non-issue.

With a Roth IRA, all income from investments and all future distributions are tax free.

That sounds better than depreciation recapture and 45-day 1031 selection windows from where we sit.

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