One of the main benefits of a self-directed IRA (SDIRA) is that you have more investment choices compared to a typical IRA account–including the ability to invest in alternative assets like private commercial real estate. But while income generated by your SDIRA is typically tax-exempt, it can be subject to an unrelated business taxable income (UBTI) tax when engaging in certain “eligible taxable activities.”
Among those “eligible activities” is the buying and selling of real estate.
Investing and taxes have always gone hand-in-hand. And prudent planning isn’t just about paying the least amount of tax; it is about understanding the tax consequences of your investing decisions. Since you’re able to use your SDIRA to invest in real estate deals on the CrowdStreet Marketplace, we wanted to make sure that you understand the tax implications of doing so.
Scenario #1
You had the opportunity to invest $100k in an LLC that acquired an office building for $10MM. The LLC purchased the property without debt, therefore your $100k investment equated to 1% ownership of the LLC. The property distributed 90% of operating cash flow for five years and it ultimately sold for $11.25MM. While CrowdStreet almost never has a deal with no debt, it’s helpful to see how the numbers pan out.
| Yr 1 | Yr 2 | Yr 3 | Yr 4 | Yr 5 | |
| LLC Taxable Income/(Loss) | $382,000 | $400,000 | $418,000 | $438,000 | $2,800,000 |
| A’s Cash Distributions | $5,400 | $5,600 | $5,700 | $5,900 | $122,000 |
| Cumulative Taxable Income | Pre-tax IRR | After-tax IRR | |
| SDIRA | $0 | 8.4% | 8.4% |
| Individual – 37% tax bracket | $44,400 | 8.4% | 5.6% |
| Individual – 24% tax bracket | $44,400 | 8.4% | 6.0% |
For real estate investments, UBTI is typically caused by using debt to finance the purchase of the property. In this scenario, there was no UBTI generated since there is no debt on the property and using your SDIRA provided the same pre-tax and after-tax return.
Scenario #2
Same as scenario #1, except the LLC financed 60% of the acquisition with debt. Your $100k investment then equaled 2.5% ownership in the LLC.
| Yr 1 | Yr 2 | Yr 3 | Yr 4 | Yr 5 | |
| LLC Taxable Income/(Loss) | $54,000 | $46,000 | $70,000 | $94,000 | $2,464,000 |
| A’s Cash Distributions | $4,600 | $4,200 | $4,600 | $5,000 | $150,000 |
| Cumulative Taxable Income | Pre-tax IRR | After-tax IRR | |
| SDIRA | $42,675 | 11.7% | 9.6% |
| Individual – 37% tax bracket | $68,200 | 11.7% | 8.5% |
| Individual – 24% tax bracket | $68,200 | 11.7% | 9.5% |
The SDIRA pays UBTI on the percentage of income that is debt-financed each year, which brings the after-tax return in line with an individual in the 24% tax bracket. Please note that investments made via a Solo 401k are not subject to UBTI on debt-financed real estate in the same manner as SDIRAs.
Scenario #3
Same as scenario #1 except the LLC financed 75% of the acquisition with debt. Your $100k investment equaled 4% ownership in the LLC.
| Yr 1 | Yr 2 | Yr 3 | Yr 4 | Yr 5 | |
| LLC Taxable Income/(Loss) | ($28,000) | ($42,000) | ($18,000) | $8,000 | $2,379,000 |
| A’s Cash Distributions | $4,600 | $4,200 | $4,600 | $5,000 | $137,000 |
| Cumulative Taxable Income | Pre-tax IRR | After-tax IRR | |
| SDIRA | $38,125 | 14.6% | 11.8% |
| Individual – 37% tax bracket | $91,960 | 14.6% | 11.0% |
| Individual – 24% tax bracket | $91,960 | 14.6% | 13.0% |
As the debt amount increases, the difference in after-tax returns for the SDIRA continues to be negated. The after-tax returns on the same dollar investment increased in scenarios 2 & 3 since leveraging the property increased your ownership percentage.
Scenario #4
You had an opportunity to invest $100k in an LLC acquiring a multi-family apartment property for $4.25MM. The LLC borrowed $2.25M for the acquisition, so your $100k investment equaled 5% ownership of the LLC. Additionally, the LLC borrows $1MM for capital improvements on the property. The property distributed 40% of operating cash flow for four years and sold for $6.4MM.
| Yr 1 | Yr 2 | Yr 3 | Yr 4 | |
| LLC Taxable Income/(Loss) | ($441,000) | ($461,000) | $94,000 | $2,749,000 |
| B’s Cash Distributions | $3,800 | $3,400 | $3,700 | $173,000 |
| Cumulative Taxable Income | Pre-tax IRR | After-tax IRR | |
| SDIRA | $79,600 | 17.1% | 14.3% |
| Individual – 37% tax bracket | $97,000 | 17.1% | 13.6% |
| Individual – 24% tax bracket | $97,000 | 17.1% | 14.6% |
Due to the short hold time and accelerated tax deductions allowed for the improvements, there were cumulative passive losses on the rental activity before the sale. Upon disposition, the SDIRA reduces it’s capital gains by these passive losses. You are then allowed to use those passive losses against other ordinary income taxed at higher rates, resulting in an additional tax benefit compared to the SDIRA.
Scenario #5
You had an opportunity to invest $100k in an LLC acquiring a hotel for $15MM. The LLC borrowed $10MM for the acquisition, therefore your $100k investment was a 2% ownership of the LLC. Additionally, the LLC used all operating cash flows on capital improvements on the property for three years. The property distributed 50% of operating cash flow in years four and five and sold the hotel for $18.7MM in year six.
| Yr 1 | Yr 2 | Yr 3 | Yr 4 | Yr 5 | Yr 6 | |
| LLC Taxable Income/(Loss) | ($379,000) | ($362,000) | ($353,000) | $247,000 | $295,000 | $7,023,000 |
| C’s Cash Distributions | $0 | $0 | $0 | $5,900 | $6,300 | $201,800 |
| Cumulative Taxable Income | Pre-tax IRR | After-tax IRR | |
| SDIRA | $129,500 | 13.7% | 9.8% |
| Individual – 37% tax bracket | $129,500 | 13.7% | 9.7% |
| Individual – 24% tax bracket | $129,500 | 13.7% | 11.3% |
The operations of a hotel are subject to UBTI, so the SDIRA is taxed on all income regardless of the percentage of debt on the property each year.
Five Things to Consider
Before deciding to use your SDIRA to make a real estate investment, consider the following factors:
Will the investment generate UBTI? If so, is it due to the type of income or because the project is debt-financed? As we saw above, if the UBTI is due to debt financing then the after-tax return may be more in line with a standard investment.
Will you have any passive income from other sources? After the major tax reform of the Tax Cuts and Jobs Act of 2017, SDIRA and other tax-exempt entities may only utilize passive losses against future taxable income from that specific investment. Real estate investments often generate tax losses in the early years. Individuals with multiple real estate investments can net the loss activities with those generating income, thereby reducing or eliminating the need for current tax payments. SDIRAs no longer can net multiple investments and would need to pay taxes each year on those with taxable income. The timing of utilizing the losses should be taken into account when analyzing the after-tax cash effect of investments.
What tax bracket do you expect to be in during the life of the investment? This may be the most difficult to determine since it depends on many other factors that may or may not be beyond your control. We do know that through 2025 SDIRAs are taxed at the highest tax rate of 40.8%, including the net investment income tax. If you expect to be in the highest tax bracket for the foreseeable future, the above scenarios show the after-tax return is similar to investments made in an SDIRA. If you don’t expect your taxable income to consistently be in the highest tax bracket then the SDIRA will not be as tax efficient as using after-tax assets.
When do you plan on retiring and pulling funds out of your SDIRA? The analysis above accounts for the after-tax IRR for the SDIRA investment only. It’s also vital to consider the liquidity of the potential real estate investment. The SDIRA must have cash available to pay its UBIT, and, if you are nearing age 70 ½ and will also need cash to pay required minimum distributions.
Will state taxes have an impact on your investment? The examples above did not consider the state tax impact on the after-tax IRR, but depending on where you live and what state the potential investment is in it could have an impact.
The above factors are not a comprehensive list of tax questions to consider when making a real estate investment but are some of the most significant. As always it is best to discuss with both your financial and tax advisors before making any investments.