Like Kind Exchanges: Capital Gains versus Ordinary Income

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July 07, 2006
Author: , J.D. LL.M.

When clients engage in a Section 1031 exchange, they often can defer capital gain taxes on the sale of investment real estate at a rate of 15% (federal tax) plus state tax. If the client has depreciation on the property sold, then the client’s tax rates are higher based on the type and amount of depreciation taken. One recent planning technique, which is causing commotion in real estate circles is the use of a self-directed IRA or self-directed Roth IRA to hold real estate properties in an attempt to defer taxes on the sale of the investment property.

The promise of tax freedom by the IRA Promoter is, unfortunately, not met in actual real life situations. IRA investors/clients who blindly follow IRA promoters may end up paying an average of 2 to 3 times the tax rates on distribution or termination of the IRA, as compared to an investor/client that did nothing to reduce their taxes.

Here are commonly promoted ways a self-directed IRA or ROTH IRA are used to hold real estate:

  1. The self-directed IRA acquires an option to purchase real estate for a nominal sum of money. The owner of the IRA arranges for the sale of the property to a third party for an amount in excess of the option on behalf of the IRA. The IRA pockets the excess into its account as profit.
  2. The self-directed IRA purchases a rental property for $250,000.00 and collects rents of $1,250.00 per month for a 6% return.
  3. The self-directed IRA purchases an investment property, rehabs the property and then sells the property on behalf of the IRA for a profit.
  4. The self-directed IRA loans $120,000.00 to an unrelated individual.

The above promoted techniques can be disastrous for the real estate investor/client for the following reasons:

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In situation #1: The activities of the owner of the IRA to arrange the sale of the property to a third party would likely be treated as a prohibited transaction between the owner and the IRA. Prohibited transactions result in termination of the IRA’s tax exempt status and the distribution of all assets to the owner as taxable income, plus penalties. Further, the income generated on the sale would be considered income assigned to another party taxable to the owner, as well as violating IRS Notice 2004-8.

In situation #2: If the IRA used debt to purchase the property, the debt incurred to purchase the property would subject the rental income to tax, known as UBTI (unrelated business taxable income). Secondly, the owner would lose the tax benefits of depreciation deductions, as well as lower income tax rates on the sale of the property. A non-IRA owner of real estate is subject to 15% income tax on the sale of appreciated property (excluding depreciation recapture). All distributions from an IRA are taxed at [higher]ordinary income rates. Finally, the IRA owner cannot receive one penny of income or management fees while the IRA owns the rental real estate.

In situation #3: The purchase, rehabilitation, and sale of property would likely be treated as trade or business income and would result in UBTI. In this case, the IRA would need to pay income taxes on the gain from the sale of rehabbed property. The owner cannot take money out of the IRA without additional taxes and penalties. Since the use of an IRA to operate a trade or business violates current tax rules and regulations, this may result in additional tax penalties. Alternatively, the increase in value associated with the rehabbing of the property would be treated as taxable income to the owner of the IRA under assignment of income doctrine.

In situation #4: Assuming the IRA owner is not in the business of making loans, the default on the loan will result in the loss of the entire investment. This is especially disastrous where the client is unable to take a tax loss of the defaulted loan.

As you can see, if a client entered into one of the above transactions the potential outcome could be a financial tragedy. It is important to advise your client that if something sounds too good to be true, it probably is. Rely upon Strategic Property Exchanges, LLC to guide you and your clients safely though complex income tax deferral strategies. Visit us at likekindexchangeservices.com.

Stephen L. Robison, J.D., LL.M.
steve@robisontaxlaw
Liza A. Kotlarsic, J.D.
liza@robisontaxlaw
Strategic Property Exchanges, LLC
4500 Cooper Road, Suite 305
Cincinnati, OH 45242
PHN (513) 412-3481
FAX (513) 412-3482

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