Real Estate in Your Retirement Account

By: Steven Weintraub

Real estate has always been an attractive asset class offering the potential for cash flow, appreciation, diversification, the ability to leverage returns, and unique tax benefits. A significant number of individuals on the Forbes most-wealthy list arrived there via real estate. The recent 7.9% reading on the Consumer Price Index should serve as a catalyst for exploring real estate as a traditional inflation hedge. 

Real estate can be purchased individually but requires substantial start-up capital (especially on the west coast), along with time, talent, and temperament. Absent those, individuals can pool capital with others and rely on professional management. Real Estate Investment Trusts (REITs) are liquid (can be sold with the press of a button) but their dividends are subject to ordinary income tax rates. The tax inefficiency makes REITs a better fit for tax deferred accounts such as a 401(k) or IRA.

Although subject to regulations requiring a high net worth, partnerships provide an alternative vehicle for individuals. These are “pass through” entities for income tax purposes, meaning that whatever happens at the entity level, each partner reports their proportionate share. The best way to take advantage of the potential tax advantages is by owning real estate partnerships personally, outside of a retirement plan. 

Let’s go through a few of the income tax basics.

Depreciation is an accounting concept that allows for annual deductions against income with no cash expenditure. Because of depreciation, cash flow typically exceeds taxable income.  These deductions would get lost inside a retirement account.

Capital gains rates, more favorable than ordinary income tax rates, generally apply to the sale of real estate (prior depreciation is recaptured as ordinary income). Any loss resulting from the sale of a property can, with limitations, be applied against ordinary income for the individual. Real estate gains, though deferred inside a retirement plan, eventually are taxed as ordinary income. Losses provide no benefit. 

Like-kind exchange provides the opportunity to defer gains to the individual investor. This allows an individual to gradually buy more expensive properties without the friction of paying taxes.  No such provision applies to retirement plans. 

Step up of cost basis occurs upon death, eliminating all deferred income taxes and freeing a beneficiary to sell a property without incurring income taxes. Retirement plans are not subject to step-up provisions. Beneficiaries, like the original owner, will be subject to ordinary income tax rates on every dollar distributed. 

Passive losses (where expenses exceed rental income) can sometimes provide shelter against income from other sources when real estate is held in a partnership outside a retirement plan. Losses inside a retirement plan provide no benefit.

Unrelated Business Taxable Income (UBTI) is generated from leveraged real estate.  This does not impact personal investors but can negatively impact the taxation of qualified retirement plans.  

Estate taxes can be reduced through strategic gifting strategies. Real estate partnerships are considered both “illiquid” and “minority interests” and each is afforded a discount for gift tax purposes. By way of example, every $1,000 of real estate might constitute a gift of only $600 - $700 for tax purposes.  These gifting strategies are not generally available to interests held in a retirement account.

Real estate partnerships can provide access to institutional quality properties, a reasonable initial investment, and professional management.  Holding such investments outside a retirement plan is the best strategy for most investors. In a future article, we will provide some insight on how to select such investments.