THREE WAYS TO GET TAX-FREE MONEY FROM REAL ESTATE

Recently I heard someone say, “It’s too bad there’s not a way to grow and pull money out of real estate tax free.”  They were talking about growing a real estate portfolio and having to pay capital gains tax when a property is sold. 

Instead of complaining, it might be better to ask a question.

Are there any ways to get tax-free money out of real estate?

The answer is yes.  There are also a number of strategies to defer taxes using real estate.  A couple of the best known are 1031 exchanges and installment sales.  Harland did a 1031 exchange recently with the sale of one of his properties.  But for this discussion we’ll stick with a few that can provide income free of taxes.

ONE.  Cash-out Refinance or HELOC.

You have probably heard of this one.  Suppose you own a property that has increased in value, maybe from a combination of improvements and inflation.  A mortgage may have been paid down a bit.  

Maybe you purchased the property with a 20-percent down payment and obtained an 80-percent loan.  For example, let’s say the initial cost was $125,000 with $25,000 down.  Now the house is worth $250,000.  You could refinance and get a loan for about 70-percent of the current value, or $175,000.  After paying off the original mortgage you could be left with about $100,000 in your pocket, depending on the mortgage balance.

Taxes are not due on the $100,000.  But you will need to pay it back at some point.

A HELOC, or Home Equity Line Of Credit, works in a similar way.  With a HELOC you don’t have to pull out the entire amount up front.  You could just pull out what you wish when you need it.  My wife and I have used a HELOC on a previous home to help fund repairs for a property that needed a sizeable renovation.  We later refinanced the property into longer-term financing.

You might be wondering if you can get a HELOC on a rental property.  The answer is yes.  I have talked with a mortgage broker recently here in Daytona who can do them.

TWO.  Opportunity Zones

Opportunity Zones were created under the Tax Cuts and Jobs Act of 2017.  They had two primary benefits.  Capital gains from the sale of other assets could be invested in an opportunity zone and the capital gains tax could be deferred until 2026.  The second benefit is that if the property is held for 10 years then potentially no capital gains taxes are due on the increase in value during the hold period.

We’ll focus on the second benefit as the first is only a tax deferral.

A couple of requirements are that improvements must be made to the property.  The cost of improvements must be equal or more than the original property less the land value.  These new improvements must be made within any 30-month period during the 10-years.

As you can probably imagine, this takes a long-term investment horizon.  This website, www.opportunityzonesmap.com, can be used to identify the locations of opportunity zones throughout the country.

THREE. Roth IRAs and Roth 401(k)s.

Most people don’t realize that you can own property in a retirement account.  It’s not heavily advertised because most account custodians don’t allow true self-direction outside of the stock market, annuities and certificates of deposit.  They might call the account a self-directed IRA, but they limit your investment options.

Certain custodians allow you to invest in a variety of non-traditional assets.  Real estate is one of the most common assets held by these custodians.  I’ve been holding real estate in a self-directed IRA for over ten years.  One benefit I enjoy is the ability to take a steady stream of cash when and if I choose.  This is significantly better than an annuity because the underlying real estate keeps growing in value and the rents continue to rise.

There are certain rules that must be followed when self-directing retirement accounts.  One, you usually cannot receive a personal benefit from the investment.  For example, you could purchase a beach house or condo with a Roth IRA and enjoy tax-free income.  But you are not allowed to use the property yourself.

You also cannot make improvements or repairs yourself.  All expenses are paid from the IRA account.  Someone else needs to do all the labor.  One option is to utilize a property manager to handle everything from finding and qualifying tenants, leasing, and making repairs.

There is an easier way to invest in real estate and get tax-free income with a Roth account.

Invest in a multi-family partnership such as a syndication.  Some of these investments provide an income stream.  Most are purchased to also increase in value over time by making improvements to management and the property.

When it comes time for taking distributions it can be nice having a cash flow stream that is not dependent on the stock market.  It can be even nicer when the income is tax-free.

FINAL THOUGHTS.

This is not a comprehensive list of the ways to get tax-free income from real estate.  It’s just a few to show that it is possible.

To get tax-free income takes planning and time.  There are multiple strategies available.  If you are using funds within a retirement account they need to be held at a custodian that allows true self-direction if you want to invest those funds in real estate.  Funds within Traditional accounts can be converted to Roth so that the withdrawals are tax-free.

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