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If you're new to the world of private real estate investing you may be wondering what type of accounts you should use to hold your investments?
Well, when investing in private real estate, "accounts" aren't used like they are in the traditional financial markets. Most of these investments are held in your personal name, an entity, or self-directed retirement accounts. In fact, retirement accounts are likely the only "account" you'll hold any of your real estate investments in. (Outside of REITs of course)
In this article well discuss the various private real estate investment vehicles. And whether or not you should hold them in retirement accounts, in an entity, or your personal name.
What is a Self-Directed Retirement Account?
Self-directed retirement accounts aren't all that different from traditional retirement accounts. However, most retirement accounts are held with custodians (i.e. Fidelity, Charles Schwab, etc.) that only allow you to invest stocks, bonds, mutual funds, and the like. But self-directed retirement accounts allow you to invest in a number of alternative investments, including real estate.
Just like traditional retirement accounts, there are self-directed IRAs and 401(k)s. Either account can be traditional or Roth. Opening one of these accounts is relatively easy and there are a number of custodians to choose from in the marketplace. You can fund these accounts with cash, subject to contribution limits, or by rolling over an eligible IRA or 401(k) that you currently have.
Caveats of Using Self-Directed Retirement Accounts
Self-directed retirement accounts have prohibited transaction rules that prevent you from investing with grandparents, parents, and your children through your retirement accounts. Meaning if your parents or children are raising capital for an investment, you can't invest through your retirement account.
There are also self-dealing rules that prevent you from investing alongside yourself, or in a project that you'll have significant involvement in. For example, if you're going to flip a property using your retirement account you'll need to have a third-party do most of the work. And if you are participating in a syndication as a general partner, you can't use your retirement account to invest in it as well.
There are some ways to get around to the self-dealing rules such as using a structure called a checkbook IRA. But you'll need to work closely with your IRA custodian to ensure you don't break any of the rules, otherwise, the IRS could disqualify your IRA. If that happens you may have to pay income tax and a penalty on the money inside your IRA.
Finally, certain real estate investments you make with your self-directed accounts may be subject to the Unrelated Business Income Tax (UBIT). But we'll touch on that later in this article.
Entity Vs. Personal Name
If these investments aren't in a self-directed account, then they'll be in either your personal name or an entity. For the most part, when investing in private real estate, it won't make much of a difference, at least for tax purposes, as you'll likely use an SMLLC, partnership, or trust that passes the income down to you anyway.
The choice between your personal name or an entity will be primarily for asset protection or estate planning purposes. And is something you'll need to consult your attorney and CPA about before entering into an investment.
Types of Investments
Notes & Debt Funds
One way to invest in private real estate is through debt.
You may choose to become a private lender who lends money to other real estate investors. The borrower will issue you a promissory note with a stated interest rate and loan terms. It's also common that the loan is collateralized by the underlying property.
Alternatively, you can invest in a note fund, which is when multiple investors pool their money together to invest in several notes. This, of course, reduces your risk.
If you use one of these investment vehicles, your return will be in the form of interest and can range from 6%-15%+. The biggest issue with interest is its taxed at your ordinary income rate (up to 37%) and is extremely difficult to shelter. Unless you use a self-directed retirement account. Interest earned on notes or from a note fund within a retirement account is completely tax-free.
And while there's nothing wrong with investing in notes in your personal name or entity, the tax advantages of retirement accounts make it a popular way to invest in debt.
You invest $100,000 in a note fund that generates a return of 12%. You'll receive a return of $12,000/year in the form of interest.
Let's assume you're in the 32% tax bracket. If you invest through your personal name or entity, you will pay $3,840 in tax. However, if you invest through a self-directed retirement account you'll pay $0. Of course, if you have a traditional IRA or 401(k), you'll pay tax when you withdraw the money. But your debt investments can grow tax-free within the account.
Rental Real Estate - DIY, Syndicates, Funds, and Crowdfunding
One of the many benefits of investing in rental real estate is the income is tax-advantaged. Because rental real estate has a non-cash expense called depreciation, it will often show a loss for tax purposes. Which means you may end up paying little to no tax on rental income.
For these reasons, many investors choose to hold these investments in their personal name or an entity.
There are also many investors out there looking to diversify their retirement portfolio with rental real estate and invest through their retirement accounts. However, if the property is leveraged with debt (i.e. a mortgage), you may be subject to the Unrelated Business Income Tax (UBIT).
UBIT is generated by Unrelated Debt-Financed Income (UDFI) and is taxed at trust tax rates. To simplify a complex calculation, UDFI is the percentage of the income generated by debt financing. If the property is financed using 75% debt and generates $1,000 in income, $750 is considered UDFI.
The first $1,000 of UDFI is exempt from tax. And in most cases, UBIT won't be high enough to significantly impact returns. But is still something to consider when investing through retirement accounts.
The above applies whether you invest in real estate directly, through a private syndication, fund, or crowdfunding platform.
You invest $100,000 in a multifamily syndication you identified on a crowdfunding platform. The actual property itself is held in a partnership and you invest in the partnership using your self-directed IRA.
In the first year, the property generates a loss for tax purposes due to depreciation, despite generating positive cash flow. You'll receive a K-1 that shows your IRA's share of the loss. You're not subject to UBIT because the property didn't produce taxable income.
However, a few years later the property produces net income and your share is $1,500. If the property has a mortgage that is 50% of the property's basis, then 50% of the $1,500, or $750 will be considered UDFI and subject to UBIT. But because it is under $1,000 you will be exempt from UBIT.
The Bottom Line
When investing in private real estate, retirement accounts are likely the only account you'll use hold your investments. The rest will be held in your personal name or an entity. Common entities include single-member LLCs, partnerships, and trusts, and are primarily for asset protection or estate planning purposes.