Should I use my IRA to purchase a rental property? I frequently have clients ask me this question. There are many advantages in purchasing investment property. I will discuss the advantages of purchasing investment property outside an IRA and also discuss the rules for purchasing a property using an IRA.
I personally invest in rental properties for the following reasons: 1)cash flow; 2)depreciation; and 3)leverage. Understanding these terms is critical if you want to build long term wealth using a portfolio of investment properties.
If your monthly rent exceeds the monthly property expenses, the property produces a monthly positive cash flow. Unlike many investors who invest for appreciation, I invest for cash flow and won’t purchase a rental property unless it produces a positive cash flow. Putting money down on the right property that produces a monthly cash flow will generate a profit in any economic cycle. I started purchasing rental properties in 1999 and have never lost money, because all of my properties cash flow aggregately. And, I have survived two recessions (Austin high tech bust in 2002 and recent recession).
Depreciation is a non-cash expenditure. It is an expense that is not incurred by landlord. The IRS allows landlords to depreciate the improvement of their home over a period of time. Land cannot be depreciated. The depreciation period is 27.5 years for a single family residence. For example, if you purchase a property for $125,000 and the land is worth $25,000, you can depreciate the improvement of $100,000 over 27.5 years which equates to a yearly expense of $3,636.36.
Cash flow is not the same thing as profit. Profit is calculated by taking gross rents and deducting all expenses. Principle payments are not deductible. Instead, investor depreciates property as noted above. Hence, profit is calculated by taking yearly cash flow plus yearly principle reduction. If the property profited $3,600 in a single year, the $3,636.36 depreciation wipes out the gain and produces tax fee income. If you are in a 25% tax bracket, you just saved $900 in income taxes with a tax free gain. See my blog article for more details on depreciation.
Leverage increases your return on investment. For example, you can purchase the home below market, producing instant equity. Obtaining a mortgage and using the bank’s money to generate cash flows will increase your rate of return. Appreciation should be treated as a bonus. If home does appreciate, the return on your investment is much higher if you finance property. For example, If an investor purchased a rental property for $125,000 and home appreciates 2%, or $2,500, the rate of return is 8% with a 75LTV mortgage scenario (investor put 25% down). Your rate of return quadruples compared to paying cash or using an IRA to purchase home. Add yearly profit of $3600 in tax free income (after depreciation), $900 in tax savings from $3,600 profit (if in a 25% tax bracket), and your rate of return increases to 22% the first year. Rate of return is even higher if property was purchased below market. Purchasing the right property at the right price and leveraging a 75LTV mortgage can produce a return greater than 25% the first year.
It is important to understand cash flow, depreciation, and leverage before we discuss purchasing a home with an IRA. With a normal investment property purchase, you can deduct mortgage interest, insurance, repairs, property taxes, management fees, etc. After expenses, you can depreciate the property which will offset gains or even make property realize a loss. Owing a home in an IRA negates these tax benefits. You can’t deduct the property taxes, repairs, and other expenses or take advantage of depreciation. Also, it is very difficult to get a mortgage to finance real estate inside an IRA. So you have to use the IRA and pay cash for the property. Paying cash reduces your return as noted in example above.
The IRS has strict rules that must be followed. You cannot occupy property or complete repairs. The IRA owns the property, not you. You will also need a property manager to find tenants and handle rents and disbursements. Of course, we recommend hiring a property manager, especially for out of town investors. All repairs must be paid out of the IRA. Failing to follow these rules can result in you losing the tax-deferred status of your entire IRA if you are younger than 59 ½. This can result in you owing taxes on the full value of the IRA plus 10% penalty.
In summary, it may be more advantageous for investors to purchase an investment property without using an IRA. Purchasing investment property outside an IRA will increase your rate of return, give you more flexibility to manage and work on property, produce tax free income by leveraging depreciation, and allow you to better leverage your capital by taking advantage of today’s record low interest rates. If you don’t have the down payment or cannot qualify for a mortgage, purchasing a home using an IRA is still a good alternative. Long term, we expect the rental market to remain healthy even during a recession. Higher rents and greater demand for rental properties will still generate a nice profit for investors who finance property or purchase property with an IRA.
If you have any questions, please call us at 512-257-9836. Our office provides sales, leasing, property management, and mortgage services.