How To Enjoy Tax Free Retirement Income (part2)!

Our last post discussed some of the tax planning advantages of owning real estate in your IRA or 401(k) plan. To summarize:

  • The IRS taxes your retirement account based on its Fair Market Value (FMV)
  • Non-marketable holdings can have a discounted value for taxpaying purposes
  • Case law has shown that the IRS will allow up to a 40% discount when valuing a non-marketable asset held by retirement plans
  • It may make sense to convert a holding and pay taxes now rather than waiting for that elusive “lower tax bracket” promised during your retirement years

Now let’s look at another type of asset that can be held by IRAs and 401(k)s. These are commonly called a private placement, Reg. D offering, or even a hedge fund. These are a type of exempt security (exempt from registration) and have no secondary market.

To differentiate between an exempt and non-exempt security, think of a Mutual Fund as a non-exempt security. You can buy and sell your shares on the open market, it is priced at its Net Asset Value (NAV) at the end of each business day, thousands of shares and investors are involved in it, and all of this is a matter of public record.

An exempt security is much the opposite. While it is still a security, the exempt status removes it from public record (generally speaking – hence the term private placement), and essentially forbids any share holder to sell their stake in the holding to another third party.

This very limited liquidity is the key to accessing a discounted valuation when converting, distributing or calculating a 701/2+ year olds’ Required Minimum Distribution (RMD).

Let’s Look at an example:

ABC Financial Services has a placement that has purchased a $4MM commercial property. It is holding, improving, and managing this property for the benefit of its investors, and plans to collect and distribute rents while waiting for the property improvements and increasing rents to allow the placement fund to sell the property at a profit.

Mr. Investor has used his self-directed 401(k) plan to purchase $100,000 worth of the units in the placement. He wishes to convert his holding to the Roth portion of his 401(k) to pay taxes now and enjoy tax free income when he retires. If he owned stocks, bonds, or mutual funds with his account, the conversion would be taxed at the full $100,000 because the NAV equals the FMV of the holdings (no liquidity restrictions).

If Mr. Investor has a tax rate of 30% his tax bill would be $30,000. However, since he owns units in a non-marketable type of security, the IRS could allow a 25% to 40% discount in the FMV of his holding. If a third party qualified appraiser provided a 40% discount in its valuation of this private placement for fair market valuation reasons Mr. Investor’s tax bill would be significantly reduced.

$100,000 Net Asset Value – 40% Discount ($40,000) = $ 60,000 Fair Market Value

Mr. Investor would pay taxes on $60,000. At his 30% tax rate his tax bill would now be $18,000! This gives him an effective tax rate of 18% today, and tax free income, distributions, and he can leave the 401(k) Roth account to his kids or grandkids income tax free.

Now let’s assume for a moment that Mr. Investors holding is the same as before, but the fund management has a loan against this property for $2MM. His holdings net value would be reduced by the outstanding loan since this would have to be paid off upon sale of the property.

$100,000 Asset Value – 40% Discount ($40,000)= $60,000 Net Asset Value

$60,000 Net Asset Value – outstanding loan of $50,000= $10,000 Fair Market Value

Mr. Investor would pay taxes on $10,000. At his 30% tax rate his tax bill would now be $3,000! This gives him an effective tax rate of 3% today, a rate he would likely never see during retirement. Oh and he still gets the tax free income, distributions, and he can still leave the 401(k) Roth account to his kids or grandkids income tax free.

As we discussed in our last post it is not so simple as to just assign a value to the transfer. You must use a qualified third party appraisal firm to establish the appropriate FMV and discount factor. Please keep in mind this is an illustration and is not specific tax or legal advice. Your circumstances will differ from these and your taxes might be higher or lower than those shown. Also, there will be  appraisal costs to consider, although many private placement managers will provide their investors with these valuations upon request.

It is so critical to know the powerful planning strategies owning real estate (or better yet – real estate held in a private placement) inside your retirement account can offer. All you have to do is start now and tax free income is yours to have – with a little planning.


About Roger Simard

Roger P. Simard, CFP® Roger P. Simard is the founding principal of Genesis Financial Advisors, LLC, and Genesis Tax Advisors, LLC. He heads the firm's corporate and personal financial planning practice and oversees all operations. Mr. Simard concentrates his work in the fields of financial planning, real estate investing, tax planning, and portfolio management. Mr. Simard is a Certified Financial Planner™ and has over 23 years of experience helping individuals and businesses achieve financial success. Mr. Simard was a speaker for The Prudential Spirit of Community Awards, a nationwide youth recognition program honoring secondary school students for outstanding service. He is a frequent speaker and radio guest on business and taxation issues and successful investment strategies and provides Continuing Education classes for Realtors.
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