Levered the IRA rental, and the 990-T prep cost more than the tax

Two years ago I bought a $215,000 three bed in a decent suburb inside a traditional SDIRA. $112,000 IRA cash down, $103,000 non-recourse at 7.9 percent on a 25 year amortization with a 5 year balloon. Lender wanted 48 percent down and six months of payments in reserve inside the account, which I'd budgeted for. Rent $1,875.

The thesis was that leverage buys a better house in a better school district than $112,000 buys all cash, and the UDFI tax on the debt-financed portion would be a rounding error against the appreciation. The first half of that was right. The house is genuinely better than the $128,000 version I'd have bought otherwise.

The second half is where I got it wrong, and not in the direction I expected.

Year one: average acquisition indebtedness over average adjusted basis worked out to about 47 percent. Net rental income after operating expenses, interest and depreciation was $4,180. So $1,965 of UDFI, less the $1,000 specific deduction, leaves $965 in trust brackets. Actual federal tax owed: about $190.

The 990-T preparation was $1,150. Year two it was $1,050. My state also wanted a return, another $300 across the two years. So $2,500 of compliance spend against $410 of actual tax across two years, on an asset held in a tax-advantaged account whose whole point was to not pay tax.

Add the loan costs: $4,300 in origination, appraisal and lender legal at close. And the rate is 7.9 against a comparable conventional at the time closer to 6.4, which on $103,000 is roughly $1,500 a year of extra interest that a non-IRA buyer wouldn't be paying.

Run it all the way out and the levered version is ahead only if appreciation on the extra $87,000 of house clears about $6,000 a year, which in this market it hasn't yet.

What I'd do differently: I'd have run the compliance cost as a fixed annual line item before I ran the tax, because the tax was never the expensive part. And I'd have priced the balloon. Refinancing a non-recourse IRA loan in year five is a real event with real costs, and I put a zero in that cell.

2 replies

1raj_mehta14CapitalPRO6

So the $1,000 deduction basically wipes out the tax at your income level and you're left paying someone a thousand a year to document that you owe almost nothing. That's a genuinely funny outcome and I'm sorry it's yours.

Question, because I'm still learning this: does the 990-T cost scale up if the property gets bigger, or is it a flat annual thing? Because if it's flat, doesn't that argue for one big levered property instead of one small one, rather than for no leverage at all?

1jessreyes12AU1APRO8

@vellum that's the right question and it's mostly flat with some scaling. Which means @marlow's loss reads as a scale problem to me more than a leverage problem. $103,000 of debt is too small to carry $1,250 a year of fixed compliance.

@marlow the other thing I'd have wanted before signing is a look at the Solo 401(k) route, if you've got any self-employment income at all. The debt-financed piece is generally treated differently there and the whole 990-T question can change shape. I'm not qualified to tell you whether you'd have been eligible and neither is anyone else here, but it's an hour with a CPA that would've been worth having before you paid $4,300 of loan costs.

The balloon is the part that worries me now, honestly. Five year balloon on a non-recourse loan in an IRA means you need a lender willing to write to an IRA in year five, at whatever rates exist then, with fees that come out of the account. What's your cash position looking like against that?

Levered the IRA rental, and the 990-T prep cost more than the tax

2 replies