Problems with IRAs and 401(k)s you probably never heard about
Posted by John Reed on
A financial investment problem I never see discussed is redundant tax shelter. Also, when you need to move fast, having assets in an IRA or other tax deferred pension account will greatly hamper your efforts to escape that “burning theater.”
.
Generally, the IRA, 401(k) and so forth tax deferred pension trustees refuse to handle real property like a duplex you own. But many investors gleefully report they found a trustee who WILL manage your duplex or other building in an IRA account.
.
For one thing, these trustees are typically laughably lacking in financial strength, long-term trustworthy reputation, and proven record.
.
But, why bother about that? Real estate already is tax deferred. If you buy a duplex and rent it out and you have an 80% mortgage, you will have no taxable rentable income for years. Why not? The deductible operating expenses will consume about 45% of the gross rents and the mortgage interest will consume more than the other 55%. Not only will you not pay income tax on the net rental income for years, even when the rents go up so much that you finally have positive cash flow after paying the mortgage, you still will have no taxes to pay because all the losses you could not deduct since day one, were suspended and may now be deducted again zeroing out the tax on any positive rental income.
.
Also, as a general rule, when you sell the duplex or other rental property, the long-term gain on appreciation of the property value will be taxed at long-term capital gains rates which are usually lower than ordinary income tax rates. But if you put the property inside an IRA or 401(k) or SEP, you get robbed of you right to the long-term capital gains rates. When you withdraw money from an IRA, etc. the entire amount including principal, net rental income, and appreciation in price, is ALL taxed at the high ordinary income tax rates.
.
Then there was this conversation I had with my brother-in-law in August 2016. “I only have months to live. I own three properties. Should I sell them now or let Marty (his sister, my wife) inherit them?”
“What are you trying to accomplish?”
“Maximize her net.”
“Then DON’T sell them. Let her inherit them. If you sell them now, you have to pay federal and state long-term capital gains tax on the appreciation since you bought them and 28% recapture tax on all the depreciation deductions you took or could have taken during your ownership. If she inherits them, her basis is the fair market value of the properties on the date of your death. The gains tax is the sale price minus the seller’s basis. YOUR basis is quite low: your purchase price minus all depreciation deductions. Marty’s basis would be the sale price if she sold immediately, so subtracting the FMV from the sale price would be zero by definition.”
.
So if your heirs will inherit the property in the IRA, it is already totally sheltered from gains tax by stepped up basis (IRC §1014).
.
There is also IRC §1031. That defers all tax on exchanges of one business or investment property for another. Real estate investors who are not cashing out all buildings, routinely use §1031. It makes the “sales” tax free so what is the benefit of the property being in an IRA? Zilch.
.
So if you are putting rental property in IRAs, etc., do not be surprised when your financial genius secret decoder ring never arrives.
.
I am not in the bond market. Is anyone there putting tax-free municipal bonds into IRAs, etc. I assume no one needs me to point out the stupidity of that.
.
IRAs, etc. have annoying annual limits on making contributions to the account. If you have a rental property in an IRA, and you go over there to make an improvement or repair, and you already contributed the max in cash, that improvement or repair is an illegal excess contribution and invalidates your IRA.
.
Then there are the restrictions and penalties on withdrawals. If and when hyperinflation hits, everyone will be frantically trying to convert all USD-denominated assets like bonds into non-USD-denominated assets like foreign currency and bullion coins, and so forth. If you have your USD-denominated are in your IRA, you will get severely hurt trying to get them out of the IRA. Foreign exchange cannot be in an IRAs because they have to be in US trustees and that means the government will outlaw having them in the US. Similarly, although you can put some precious metal coins minted by the US government into an IRA, they must be held by an IRA custodian, not you, plus, in 1933, FDR issued Executive Order 6102 https://en.wikipedia.org/wiki/Executive_Order_6102 which ordered all Americans who had bullion gold to sell it to the US Federal Reserve for a below-market price.
.
Trying to convert USD-denominated assets inside your IRA to non-USD-denominated assets also within your IRA can only be done with a few types of such assets and having to make such switches on an emergency basis will likely result in your losing a lot of the purchasing power of your USD IRA assets because of delays. If your USD assets are NOT in an IRA, you just use them to buy nonUSD stuff immediately.
.
As long and detailed as this article is, I probably overlooked some other redundancies and flee the “burning theater” issues caused by IRAs, etc.
.
Generally, the IRA, 401(k) and so forth tax deferred pension trustees refuse to handle real property like a duplex you own. But many investors gleefully report they found a trustee who WILL manage your duplex or other building in an IRA account.
.
For one thing, these trustees are typically laughably lacking in financial strength, long-term trustworthy reputation, and proven record.
.
But, why bother about that? Real estate already is tax deferred. If you buy a duplex and rent it out and you have an 80% mortgage, you will have no taxable rentable income for years. Why not? The deductible operating expenses will consume about 45% of the gross rents and the mortgage interest will consume more than the other 55%. Not only will you not pay income tax on the net rental income for years, even when the rents go up so much that you finally have positive cash flow after paying the mortgage, you still will have no taxes to pay because all the losses you could not deduct since day one, were suspended and may now be deducted again zeroing out the tax on any positive rental income.
.
Also, as a general rule, when you sell the duplex or other rental property, the long-term gain on appreciation of the property value will be taxed at long-term capital gains rates which are usually lower than ordinary income tax rates. But if you put the property inside an IRA or 401(k) or SEP, you get robbed of you right to the long-term capital gains rates. When you withdraw money from an IRA, etc. the entire amount including principal, net rental income, and appreciation in price, is ALL taxed at the high ordinary income tax rates.
.
Then there was this conversation I had with my brother-in-law in August 2016. “I only have months to live. I own three properties. Should I sell them now or let Marty (his sister, my wife) inherit them?”
“What are you trying to accomplish?”
“Maximize her net.”
“Then DON’T sell them. Let her inherit them. If you sell them now, you have to pay federal and state long-term capital gains tax on the appreciation since you bought them and 28% recapture tax on all the depreciation deductions you took or could have taken during your ownership. If she inherits them, her basis is the fair market value of the properties on the date of your death. The gains tax is the sale price minus the seller’s basis. YOUR basis is quite low: your purchase price minus all depreciation deductions. Marty’s basis would be the sale price if she sold immediately, so subtracting the FMV from the sale price would be zero by definition.”
.
So if your heirs will inherit the property in the IRA, it is already totally sheltered from gains tax by stepped up basis (IRC §1014).
.
There is also IRC §1031. That defers all tax on exchanges of one business or investment property for another. Real estate investors who are not cashing out all buildings, routinely use §1031. It makes the “sales” tax free so what is the benefit of the property being in an IRA? Zilch.
.
So if you are putting rental property in IRAs, etc., do not be surprised when your financial genius secret decoder ring never arrives.
.
I am not in the bond market. Is anyone there putting tax-free municipal bonds into IRAs, etc. I assume no one needs me to point out the stupidity of that.
.
IRAs, etc. have annoying annual limits on making contributions to the account. If you have a rental property in an IRA, and you go over there to make an improvement or repair, and you already contributed the max in cash, that improvement or repair is an illegal excess contribution and invalidates your IRA.
.
Then there are the restrictions and penalties on withdrawals. If and when hyperinflation hits, everyone will be frantically trying to convert all USD-denominated assets like bonds into non-USD-denominated assets like foreign currency and bullion coins, and so forth. If you have your USD-denominated are in your IRA, you will get severely hurt trying to get them out of the IRA. Foreign exchange cannot be in an IRAs because they have to be in US trustees and that means the government will outlaw having them in the US. Similarly, although you can put some precious metal coins minted by the US government into an IRA, they must be held by an IRA custodian, not you, plus, in 1933, FDR issued Executive Order 6102 https://en.wikipedia.org/wiki/Executive_Order_6102 which ordered all Americans who had bullion gold to sell it to the US Federal Reserve for a below-market price.
.
Trying to convert USD-denominated assets inside your IRA to non-USD-denominated assets also within your IRA can only be done with a few types of such assets and having to make such switches on an emergency basis will likely result in your losing a lot of the purchasing power of your USD IRA assets because of delays. If your USD assets are NOT in an IRA, you just use them to buy nonUSD stuff immediately.
.
As long and detailed as this article is, I probably overlooked some other redundancies and flee the “burning theater” issues caused by IRAs, etc.
Share this post
0 comment