Paper inside the IRA, buildings outside it. What breaks in that logic?

Question

I've got a couple of small multifamily buildings held personally and an old employer 401k I can roll. The reasoning I keep landing on is that depreciation, cost segregation and 1031 exchanges are all worth nothing inside a retirement account, so putting a building in there throws away the best part of owning a building. Meanwhile interest income is the thing that gets taxed hardest in my personal return, at ordinary rates, and it's the thing that's exempt from UBIT inside the IRA.

So the IRA holds notes and a debt fund position, and I keep buying buildings on the outside where the write-offs land against my other income.

I've been sitting with this for a while and it seems almost too tidy. What am I not seeing?

Rena Expert · Accepted Answer

The core of it holds. Inside an IRA, depreciation shelters nothing, 1031 is irrelevant because there's no recognition event to defer, long-term capital gain rates don't apply because everything comes out as ordinary income at distribution (traditional) or tax free (Roth), and QBI doesn't reach you. Interest is the least tax-efficient thing you can hold personally and it's clean inside the wrapper. That's why lending fits.

Three things bite that your framing skips.

Losses stop existing. If a note inside the IRA defaults and you recover 60 cents, there is no capital loss, no bad debt deduction, nothing. The tax code doesn't see it. Personally held paper at least gives you something back. That should push your loan-to-value discipline inside the IRA tighter than outside it, not looser.

Illiquidity meets required minimum distributions. A traditional IRA has to start distributing at the age set by current law, and the custodian will not distribute a fraction of a private note easily. People end up doing in-kind distributions of illiquid assets with valuation fights attached, or scrambling for cash. Check the current RMD age and rules with your own advisor, they've moved twice in recent years.

Valuation is an annual chore. Custodians report fair market value on Form 5498 every year for private assets. For a performing note that's usually the payoff balance, easy. For a defaulted note or a fund LP interest it isn't, and some custodians want a third-party opinion you'll pay for.

There's also a prohibited-transaction trap sitting right where your two buckets touch. Your IRA can't lend to a deal you control or benefit from personally, and whether a given structure crosses that line is a facts question for a tax attorney. Keep the two sides of your balance sheet genuinely unconnected.

brandonlee36 · Answer

The RMD point is the one that got my attention. A five-year note with no amortization looks fine until you realize the distribution requirement doesn't care about the maturity date. If you're anywhere near that age band you either ladder maturities or you hold a cash sleeve, and a cash sleeve at whatever money market pays drags the blended yield down more than people expect.

dpatel_re · Answer

No loss deduction changes the underwriting, and I don't think most people adjust for it. Outside the IRA a 75 percent LTV note with a partial writeoff hurts less after tax. Inside, the recovery is the whole story. I'd underwrite IRA paper as if I were the last dollar in, and I'd care much more about whether I can actually foreclose in that state and how long the timeline runs. And if you do take the property back, congratulations, your IRA now owns a building it has to pay a third party to manage, because you can't do the work yourself.

Rena Guide · Answer

For anyone reading this who's newer, a few of the terms above:

Asset location just means deciding which account holds which investment, given that the same investment gets taxed differently depending on where it sits. It's separate from asset allocation, which is what you own.

UBIT is unrelated business income tax. Retirement accounts are tax-advantaged, so the code taxes them when they earn income that looks like an operating business or that comes from borrowed money. Rent, interest and gains from a passive position don't trigger it. Income from a fix-and-flip operation does, and so does the portion of income attributable to debt on a leveraged property.

A prohibited transaction is a deal between your IRA and a disqualified person, which includes you, your spouse, your parents, your children and entities they control. The penalty isn't a fine on the deal. The whole IRA can be treated as distributed, so a 400k account becomes a 400k taxable event.

Form 5498 is the annual report your custodian files showing what the account is worth. For publicly traded assets that's automatic. For a private note or an LP interest, the custodian asks you for a value each year, and how much documentation they want varies a lot between providers. Ask about that before you open the account, because it's an annual cost and an annual argument if you pick the wrong one.

Paper inside the IRA, buildings outside it. What breaks in that logic?

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