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Tax Savings with a Roth IRA and Real Estate

Due to the Tax Increase Prevention and Reconciliation Act of 2005, all holders of IRAs (SEP, SIMPLE and traditional) can convert to a Roth IRA regardless of their income. Previously, in order to be able to convert from an IRA to a Roth IRA your income needed to be under $100,000. Many IRA holders may not be aware of this strategy and as a result may be missing out on an opportunity to eliminate future taxes on their retirement plans, thereby compounding their total return.

Through a Roth conversion, you simply elect to be taxed at current individual tax rates for the total amount that you convert to a Roth IRA. You may do a full or a partial conversion. Once it is converted, any withdrawals from the Roth account after five years and achieving the age of 59.5 will be tax-free. Additionally, IRA investments in private holdings that are anticipating a step up in valuation could afford a significant tax advantage.

Real Estate Limited Partnerships

In IRAs, investors may hold different types of investments such as real estate limited partnerships, stocks and/or bonds. By purchasing a private real estate development partnership in your IRA you could potentially receive a significant valuation discount upon a Roth conversion with an appealing tax advantage.* Once purchased during the first quarter of each year, a third-party evaluation is determined for ERISA requirement. The partially completed property often values at 35–50% of the original investment during the construction phase. This creates a structured tax benefit. The private placement must receive an annual valuation under the ERISA guidelines. During the reduced fair market value per unit, there is an opportunity for a Roth conversion. In a Roth, the future growth and gains are tax-free.

Take, for example, an original IRA investment of $100,000 in a real estate limited partnership. After one to two years the real estate company provides for an independent third-party LP evaluation of the investment. Assume a 40% valuation upon which a Roth conversion will be made. The actual value of the investment moved to the Roth IRA was $100,000 and will be taxed at an assumed 40% tax bracket, then a $16,000 tax bill would be due (40% of $40,000 valuation). 

These are the taxes due after the revaluation process and because of the IRA conversion. Assuming a hypothetical 28.86% average annual return on investment and a 5.33 years holding period, the approximate value of the tax-free investment would be $253,920. (These hypothetical numbers of average return and holding period are based on past performance of a partnership. Past performance is no guarantee of future results.)

The IRS also allows you to re-characterize your Roth IRA back to a traditional IRA as long as you did the conversion in 2017, which may be valuable if your investment value declines or if your financial situation changes and you do not want to pay your tax bill that year, as you can recoup the taxes paid for the conversion. As of 2018 with Trump’s new tax law, re-characterizations no longer are allowed. Your heirs will also receive Roth funds tax-free versus at their top tax bracket. (For related reading, see: How to Add Real Assets to Your Portfolio.)                                                                                                                                       

*The amount of taxable income on a Roth conversion is based on the fair market value (FMR) of the IRA assets subject to the conversion. The lower the FMV of the IRA assets, the lower the taxes that will be due on the Roth IRA conversion. Pursuant to case law, the standard of FMV is an objective test using hypothetical buyers and sellers. In determining the valuation of an LLC the assets to be valued must be the interests in the entity. This allows a discount when determining the FMV of the IRA assets subject to the conversion, thereby reducing the amount of tax you pay on the conversion. The Roth conversion strategy is based on tested case law. The valuation discounts applicable to an LLC with IRA assets typically fall into two categories: 1) a discount for lack of control, and 2) a discount for lack of marketability. This could potentially allow you to take a discount of anywhere from 35% to 50% on the value of the IRA assets subject to the Roth conversion. The Roth conversion valuation discount strategy can save you thousands of dollars in taxes is based on established case law.