How to Invest in Real Estate w/o Paying a Penny of Tax: Part 1 Why IRAs + 401k's don't cut it
Updated: Sep 20, 2023
You can pay $0 in tax. IRA's/Solo 401k's are okay but won't get you the whole way there, due to limited tax sheltering and/or significant limitations.
(Disclaimer: I'm not an accountant, financial advisor or attorney. Always consult your own financial and/or legal advisors before making any tax, financial or legal decisions. Code of ethics: We do not receive any money from any sponsor or platform for anything including guides, tutorials, postings, reviews, referring investors, affiliate leads or advertising. Nor do we negotiate special terms for ourselves above what we negotiate for the benefit of private club members.)
Back in 1997, Gary Frederick scraped together $52,000 and placed it in a passive real estate investment. He had no idea that he'd repeat this 53 more times over the next 21 years. And that today he'd be generating so much income that he banks all the money from his "day job."
"It changed my life," says Fredrick. That alone would be amazing enough. But what's even more amazing is that Frederick did this without paying a penny of tax. And when he dies, he'll pass the property on to his heirs and they won't pay any tax either.
How did he do this? Many traditional financial advisors (who only know public markets) would say it's impossible. But savvy investors like Frederick have been quietly doing this for years. They don't rely completely on IRAs or traditional retirement vehicles. Instead, they use more advanced techniques like coupling depreciation with the humorously named "defer, defer and die" technique and 1031 exchanges. And they use "passive-pairing" and more. (Also, in 2018, the new tax law opened up additional options for zero tax investing). This article series examines how it works.
Part 1 of this article looks at traditional tax sheltering methods (IRAs, solo 401(k)s) and why they often don't quite stack up. Then in Part 2, we'll look at how to maximize your tax savings while retaining your flexibility, using "defer, defer, and die" and other techniques. In part 3, we'll see how "passive-pairing" can drastically reduce or eliminate your investment taxes. And then in Part 4, we'll look at how to implement that.
The Tax Man Cometh
When you invest in real estate, you're potentially taxed in two ways.
First, the profit from renting it (net operating income) is taxed as ordinary income. Ordinary income is taxed at the same marginal rate as if you had made more money with your employer (which for most accredited investors is between 22 - 37%).
Second, you also hope that the property is worth more when you sell it. If so, then the profit from that is taxed as capital gains (which for most accredited investors is relatively lower and ranges from 15 - 20%).
Then on top of this, some people may have state and local taxes as well. It all adds up to a lot, so it's no surprise that many people want to minimize the amount of taxes they have to pay.
If you complain about this to some traditional financial planners, they'll probably recommend that you put the money into a self-directed IRA/solo 401(k). This definitely works to reduce some of your taxes (and I did an article on how to liberate your traditional IRA to be able to do this).
However, none of these methods let you invest completely tax-free, and all have significant limitations.
Self-directed Traditional IRA
In a traditional IRA, you put in money with the idea that you're going to keep it in there until you're 59 1/2 years old (otherwise you pay a penalty). Some people can also deduct the contribution from their income (although most accredited investors can't, because they make too much money to qualify). Then it accumulates tax-free. However, at some point you have to pull the money out, and then you do get taxed. You're taxed at whatever your marginal rate is at the time.
So an IRA investor is counting on/hoping that their future tax rate in retirement is lower than their current rate, because they will have less overall income. (Others question that belief by pointing out that tax rates are currently at extreme historical lows, and that record deficits will eventually require tax hikes to fix. I won't get into that debate, for the purposes of this article, and assume that the investor will probably have a lower tax rate.).
So the main limitation of the traditional IRA is that it obviously isn't completely tax-free. It's also very limited as to how much you can put in. (Only $5500 per year or $6500 if you're age 50 or older). And if you want to pull the money out before you turn 59 1/2, you can't without paying a hefty 10% penalty. Finally, it can't be invested in all types of real estate, because you may be subject to UDFI/UBTI.
So this is alright, but not great.
Self-directed Roth IRA
In a Roth IRA, you don't get the initial tax deduction when you contribute like a traditional IRA. This isn't a big deal to most accredited investors, since they didn't qualify for the deduction anyway. Like a traditional IRA, and also accumulates tax-free. However, the big difference is that when you pull your money out, you're not taxed.
So this is a pretty good deal, and on the surface seems like the ideal way to achieve the goal of tax-free investing. However, a Roth IRA comes with significant downsides.
Can't invest in all types of real estate, because you may be subject to UDFI/UBTI penalties.
Can only use W-2 and self employment income. So none of your money from your taxable investments can be put into a Roth. And if you're retired and/or living exclusively off investment income, this means you can't put any money into one.
Can't add significant money. A Roth limits you to adding only $5500 per year or $6500 if you're aged 50 or older. This is a showstopper for many. (A few lucky souls have a 401k at work that lets them use a technique called the mega-back door Roth to contribute up to $32,000 per year. However, this is not a technique that the typical person can use).
Impossible or difficult to qualify to contribute yearly to a Roth. Many accredited investors make too much money to qualify to contribute to a Roth. If you make more than $135,000 per year single or 190,000 per year married, you can't contribute to one. But there is a technique called a "backdoor Roth" that allows high income earners to bypass this restriction. And it was just made explicitly legal by Congress in January 2018. However if you have other IRA funds, there are some complicated limitations, and you may not get the tax savings you were expecting. If you're considering this, make sure to consult your tax advisor and attorney first. Some investors may already have a decent pot of money in an IRA/work place 401k that has been accumulated slowly over time, and can be converted to a Roth. If so, that can make a lot of sense...even if they will run into all of the above issues with trying to adding money to it.
Limited access. If you pull your money out before you turn 59 1/2, you have to pay taxes on whatever earnings occurred in the account. This is probably not a big deal for people who are close to retirement and a lot better than paying an additional 10% penalty with a traditional IRA. But is more of an issue for younger people.
Self-directed 401(k)/Roth IRA
If you have a legitimate self-employment activity (and without full-time employees), there's an appealing option called a self-directed 401(k). When paired with a Roth IRA, it gives you the same tax sheltering as a Roth. But you can put in up to $53,000 per year (or $59,000 if you are at least 50 years old). However, the contributions can't be more than your earned income, which may limit the usefulness significantly unless you have significant business activity.
One advantage is that unlike an IRA, it is not subject to UDFI/UBIT tax. However, it does come with some other issues, because you are the custodian, and it's possible to violate the rules and owe the penalties if you invest in the wrong thing.
Note: that another way to get around contribution limits is to transfer an existing IRA pot of money into one, which may be a good option for some. Again this gets around limitations of putting money in the very first time, but will still be subject to the other limitations on a yearly basis.
So limitations here are:
Impossible to set up for many. Have to have a legitimate self-employment business without full-time employees or an IRA to rollover.
Severe to moderate restrictions on how much money you can put in (depending on your situation).
Not suitable for a newbie investor or someone who doesn't have the time to dive into the details to make sure they are not violating the rules.
This just isn't an ideal solution for everyone. And even if it does work for an investor, this technique would not be usable as a multi-decade wealth-building tool like Frederick did (who ended up putting in far in excess of $59,000 in many of his later years as his nest egg grew larger over time).
There must be a better way?
In part two of this article, we'll talk about the holy grail: how to invest taxable money and pay no taxes at all, by combining two strategies (depreciation and "defer, defer and die") and also how the new tax law opens up additional options.
Click here to view part 2.