by Tom Wheelwright
This week, I’ll share 2 Key Steps to Take Before Investing in Real Estate in Your IRA.
While I’m focusing on the U.S. tax law here, the approach can be applied to retirement plans in other countries as well.
Step #1: Understand the Special Tax Treatment Rules for IRAs
IRAs receive special tax treatment on certain types of income.
The special tax treatment is that the income is not taxed currently. In the case of a traditional IRA, it is taxed when it is distributed – the tax is deferred. In the case of a Roth IRA, it is never taxed – the tax is eliminated.
There is a very important detail that gets missed here:
The special tax treatment only applies to certain types of income.
IRAs only receive the special tax treatment on certain types of income. This income includes interest, dividends, capital gains and rents. If an IRA produces this type of income, the income is not taxed currently.
If the IRA produces income that is not in this group of tax-favored income, then it could be taxable.
What is important to remember here is not all income receives special tax treatment just because it is in an IRA.
Step #2: Understand the Type of Income Your Real Estate Will Generate
Real estate can produce many different types of income – this is one of the many reasons I love real estate.
Real estate can generate interest income, rental income and capital gains. These are all tax-favored types of income in an IRA and, as such, they receive the special tax treatment.
Real estate can also produce ordinary income. An example of this is flipping real estate where real estate is bought with the intent to sell it quickly for a profit. Ordinary income is not in the group of tax-favored income and could be taxable in an IRA.
Understanding how the income generated from your real estate will be taxed to your IRA is key to making sure your IRA receives the full benefits from the special tax treatment available to it.
Understanding the Rules
As I mentioned, there is a lot of confusion in this area. Here is a good example of this.
One person may share that they were told it was a bad idea for their IRA to invest in real estate and another person may share the opposite.
The key to clearing up the confusion is getting more specific because not all income from real estate receives favorably treatment in an IRA.
One person’s IRA may be investing in tax liens that generate interest income and another person’s IRA may be flipping real estate. One receives favorable treatment and the other doesn’t.
Starting with these two steps helps create a clearer picture of the tax consequences to your IRA. Of course, these aren’t the only steps to take and I’ll share more on the topic of real estate in an IRA in the future, but these are the key steps to take early on in the process as they can provide helpful guidance and direction.
Focus on your wealth!
Founder & CEO