Tax Savings with a Roth IRA and Real Estate

By | April 12, 2017

April 12, 2017 by Rebecca Dawson, SVP – Silber Bennett Financial

In 2010 due to The Tax Increase Prevention and Reconciliation Act of 2005, all holders of IRAs (SEP, SIMPLE and traditional) may 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. The IRS regulations have changed and there is no longer an income cap. 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 value 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.

Investing in real estate within an IRA was not always an option, with the passage of ERISA (Employee Retirement Income Security Act) IRAs have been self-directed. The owner of the IRA has the ability to direct the custodian of the account what to invest their funds into. By law, all IRAs are required to be held with a custodian.

The Roth conversion strategy is best utilized with a developmental real estate LP as was indicated above in order to qualify for the Structured Tax Benefit during the reduced fair market value with the annual third party valuation. One program that qualifies is Mill Green Opportunity Fund IV, LLC. The fund intends to raise $40 million of equity capital and expects to initially invest in a Class A multifamily development project and five to seven future multifamily, student housing or grocery anchored retail development projects. The Fund will only invest in development projects in which Preferred Apartment Communities (ticker symbol: APTS) is providing mezzanine loan financing to and entering into a purchase option to acquire the property after stabilization.

Not only do Mill Green and Preferred Apartment Communities have a long standing relationship but the CEO of Preferred Apartment Communities, John Williams, founded another successful real estate investment trust Post Properties (ticker symbol: PPS) back in 1971. Post Properties is headquartered in Atlanta, and has operations in nine markets across the country. The company employs approximately 600 people and owns approximately 20,000 apartment homes.

Mill Green Opportunity Fund IV, LLC will pay a monthly 6% per annum current distribution, a 12% per annum preference return for the first $12 million in investments, 10% preference for remaining investments. Then the remaining distributions will split 75% to investors and 25% to Mill Green Partners. The 75% of the 75/25 split is targeted to range between 4 – 6%. The expected fund life is 34 to 38 months.

Take, for example, an original IRA investment of $100,000. 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 18% average annual return on investment and a 3 year holding period, the approximate value of the tax free investment would be $154,000. (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.)

On the other hand, if the real estate investment had been not been converted to the Roth IRA and it had returned the same amount over the same holding period then when the funds are withdrawn from the traditional IRA you would be taxed on the total amount of $154,000. You would also be required to take out your annual required minimum distribution (RMD) each year thereby paying the approximate taxes due of $61,600 over a period of time assuming a 40% tax bracket.

Additionally, Mill Green targets geographic markets with high job growth in the Southeast and Mid-Atlantic U.S. where they have significant experience. Student housing is targeted for universities with greater than 10,000 enrollment and demonstrated growth with a need for additional housing. The majority (77% including 21% on campus) of purpose built student housing continues to be aged and out of touch with current technology demands. Grocery anchored retail is targeted for #1 or #2 market position such as Whole Foods or Sprout, high sales per square foot, and high sales growth. Expected life cycle of grocery anchored retail development is less than multifamily and student housing. Typically it has a 12 to 15 month construction/lease up period. ***

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.

As was mentioned above, one of the additional benefits of converting to a Roth is the avoidance of having to take the required minimum distributions (RMD) after the age of 70.5 each year. Converting a traditional IRA to a Roth IRA may give you flexibility after you reach retirement age. Contributions to a Roth IRA come from after tax income, so there are fewer restrictions on how you use these assets. Unlike a traditional IRA, which has a required minimum distributions (RMD), a Roth IRA has no required minimum distributions (RMD), so you may continue to use your Roth IRA as an investment fund for as long as you like. With a traditional IRA, you must begin to collect distributions by the age of 70.5 through annual RMDs. The RMD for each year is calculated by dividing the IRA account balance as of December 31 of the prior year by the applicable distribution period or life expectancy. Again this rule does not apply to your Roth IRAs.
*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.

**No assurance can be provided that the Fund will be able to identify suitable investment opportunities for investment. No assurance can be provided that Preferred Apartment Communities will exercise its purchase option.

*** No assurance can be provided that the Fund will achieve this result.


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