"Your IRA isn’t saving you the taxes you think it is, and in some cases, it could be costing you more than you expect."

Retoro Capital Investments

             Your IRA Isn't Saving You the Taxes You Think It Is

Once you heard of Self-Directed Individual Retirement Accounts (SDIRAs) to invest in real estate by transferring some of your existing IRA to a self-directed IRA, you likely got very excited and set off to find your first commercial real estate deal to invest in. You've heard about the great tax advantages of real estate through depreciation, so using a tax-advantaged account must mean extra tax benefits, right?

That's absolutely wrong and the number one mistake investors make when investing in real estate through an IRA.

Expecting to combine the tax advantages of real estate depreciation with the tax-deferred or tax-free growth of IRAs is often a disappointment. The IRS prohibits double-dipping on tax benefits, meaning depreciation offers little to no tax savings within SDIRAs. To make it worse, having to pay a tax when selling an asset inside an IRA that is financed by debt is often a surprise to investors when an investment exits. There are ways to mitigate that tax burden while maximizing returns, but it takes some education and pre-planning.

So how could you make the best use of depreciation and an IRA?

Let's explore the critical tax considerations of depreciation limitations, Unrelated Business Income Tax (UBIT), and the tax efficiency of private lending in Traditional and Roth SDIRAs, helping investors optimize their retirement portfolios for long-term wealth.

As always, understand we are investment fund managers, not financial advisors. We can share what works for us, examples from our own and our investors' experiences, and research we've done with our financial professionals. Do you have financial professionals? If you are an accredited investor taking your initial forays into private market investing to diversify and beat stock-market averages, it's a good idea to get some help navigating the landscape.

Depreciation in SDIRAs: Limited Utility

No Direct Tax Benefit from Depreciation

Depreciation allows property owners to deduct an asset’s cost over its useful life, reducing taxable income on passive income in non-IRA accounts (IRS Publication 946). Depreciation quantifies the loss of value of structures and real property over time, acknowledging that while land value appreciates and improvements increase value, those improvements lose value as they age and require additional maintenance, repair, or replacement. This depreciation offsets taxable passive income (passive income defined by the IRS Topic No. 425 refers to passive income coming from silent partner businesses as well as rents, which is different than the colloquial use of "passive" income).

In SDIRAs, however, depreciation provides little to no direct tax benefit because, according to IRS Publication 590-B, all income inside an IRA is already tax-deferred (in Traditional SDIRAs) or tax-free (in Roth SDIRAs after age 59½ and a five-year holding period). The IRS prevents combining depreciation deductions with IRA tax advantages to avoid double tax benefits. For example, a rental property generating passive rental income in an SDIRA cannot use the property depreciation to reduce taxes on that passive income since that income is already tax advantaged in the IRA, unlike in a taxable account, where depreciation offsets passive income.

Unrelated Business Income Tax (UBIT) and Unrelated Debt-Financed Income (UDFI)

To make matters worse, Unrelated Debt-Financed Income (UDFI) can trigger Unrelated Business Income Tax (UBIT), catching investors off guard when debt-financed assets are sold, after understanding that the double tax advantages don't exist, and now there's a new tax to pay, investors have never heard of!

Defining UBIT and UDFI

UBIT, also known as Unrelated Business Taxable Income (UBTI) or Unrelated Business Income (UBI), is a tax on income from activities unrelated to an SDIRA’s tax-exempt purpose, such as operating a business or earning UDFI from debt-financed property (IRS Publication 598). UDFI specifically refers to income or gains from assets purchased with borrowed funds, as real estate often is, taxed proportionally to the debt ratio. For example, a property with a 50% debt ratio generates 50% of its income as UDFI, subject to UBIT at corporate tax rates (up to 21% in 2025).

Calculating and Paying UBIT/UDFI

UBIT, including UDFI, is reported on IRS Form 990-T, with the custodian paying taxes from IRA funds. For a property generating $15,000 in rent with a 50% debt ratio, $7,500 is taxable as UDFI, incurring $1,575 in UBIT at 21%. If $4,000 in depreciation applies, the taxable income drops to $3,500, reducing UBIT to $735. Investors must ensure liquidity to cover UBIT without selling assets.

Minimizing UBIT/UDFI Exposure

To avoid UBIT/UDFI, investors can use cash purchases for SDIRA real estate or focus on non-leveraged assets like private loans, also known as private notes. Lowering debt ratios (e.g., 25% instead of 50%) also reduces taxable income, minimizing UBIT liability.

Using Depreciation to Offset UBIT

Offsetting that taxable income inside an IRA is one niche use of depreciation, including taxes on UDFI, generated by debt-financed assets. Depreciation can reduce the taxable portion of income subject to UBIT, lowering the tax liability paid from IRA funds. While UBIT is often unexpected, depreciation can offset the sting of it. However, that leaves most of the depreciation unused, which often isn't a fair trade-off. There are other niche applications for using depreciation on investments inside an IRA, but by and large, it's lost when holding equity in real estate in an IRA.

Implications for Investors

The ability to use depreciation to offset UBIT is usually the only tax-related benefit of depreciation in SDIRAs, but it’s limited to debt-financed assets and does not enhance overall tax savings like in taxable accounts. Real estate professionals or investors offsetting passive income (IRS Topic No. 425) gain far greater depreciation benefits by holding properties that generate rental income in taxable accounts. SDIRAs are often considered better ideal for non-depreciable assets like private loans or land, where tax-advantaged growth is maximized.

Strategic Asset Placement

We self-manage many of our smaller rentals and hold them in taxable cash accounts for two reasons. First, because investments in an IRA must be hands-off, truly passive investments without direct material involvement in managing the business. Second, we use that depreciation to offset our active income generated by activities that are taxed as ordinary income, such as loan interest from lending to other entrepreneurs, manager distributions from our fund, consulting and contracting, or part-time work.

In summary, for us, depreciable assets like rentals are what we hold in our taxable accounts to leverage deductions, while SDIRAs are ideal for non-depreciable assets like private loans or land.

Exceptions for Holding Equity Real Estate in SDIRAs Despite UDFI and Depreciation Limitations

While UDFI and the inability to use depreciation make equity real estate less attractive in SDIRAs, certain situations justify holding these assets despite the drawbacks.

• High Appreciation Potential: Properties expected to generate significant capital gains can benefit from SDIRA tax advantages. In a Traditional SDIRA, gains are tax-deferred, and in a Roth SDIRA, they are tax-free after age 59½ and a five-year holding period. This can outweigh UDFI costs and perhaps even loss of depreciation if the property’s value increases substantially.

• Low Debt Ratios: Properties with minimal or no debt financing reduce or eliminate UDFI, making equity real estate more viable. Cash-funded properties avoid UBIT entirely, and depreciation’s absence is less critical if rental income is modest compared to appreciation.

• Unlevered Capital Structures: Equity investments as a limited partner in a real estate syndication or fund can minimize management demands and UDFI if the deal avoids leverage. The tax-advantaged growth of SDIRAs can outweigh depreciation losses for passive investors.

• Long-Term Hold Strategy: Investors planning to hold properties for decades can prioritize tax-free or tax-deferred growth over immediate depreciation benefits, especially in Roth SDIRAs. This is suitable for assets in high-growth markets that may have weak cash flow.

• Tax Bracket Considerations: Investors in lower tax brackets or anticipating lower future brackets may find UDFI’s tax impact negligible compared to the benefits of tax-deferred or tax-free gains in SDIRAs, especially for properties with high income or growth potential.

• Availability of Funds: When an investor finds a particularly good equity deal and funds are only available through an IRA, it could be better to get involved and take the trade-off of using a tax-advantaged account versus using depreciation.

Balancing Trade-Offs

Holding equity real estate in SDIRAs is warranted when appreciation or passive income potential significantly exceeds UDFI costs and the loss of depreciation benefits. Investors must weigh the expected returns against UBIT liabilities and consider cash purchases or low-debt structures to minimize tax exposure.

A Better Plan: Private Lending For A UDFI-Free, Tax-Efficient Strategy

High Taxes on Interest in Taxable Accounts

Interest from private lending, such as hard money loans, is taxed at ordinary income rates up to 37% in 2025 (IRS Publication 550). A $150,000 loan at 10% APR generates $15,000 annually, incurring up to $5,550 in taxes in a taxable account, reducing net returns to $9,450. This tax burden diminishes lending’s appeal outside tax-advantaged accounts.

Tax Deferral in Traditional SDIRAs

In a Traditional SDIRA, interest income is tax-deferred, allowing the full $15,000 to compound. Reinvesting at 10% APR over five years achieves a 13% internal rate of return (IRR). Cash-funded loans avoid UDFI, ensuring no UBIT liability.

Tax-Free Growth in Roth SDIRAs

Roth SDIRAs offer tax-free interest income after age 59½ and a five-year holding period. The $15,000 annual interest grows without tax, achieving a 13-15% IRR over five years. These loans also avoid UDFI, making them a high-return, low-risk option.

Why Lending Excels in SDIRAs

Private lending, especially hard money loans de-risked by first-lien collateral, avoids UDFI and UBIT, as it involves extending rather than receiving credit, therefore no debt financing or business operations. Inside an IRA, the private lending must be hands-off in a business that the investor does not manage to originate or service loans. With stable 10-12% APR returns and low risk, lending often outperforms equity investments in 5-year IRR comparisons, especially when equity investments lack depreciation benefits inside SDIRAs, and carry higher risks of underperformance.

Tax Optimization Strategies for SDIRAs

Maximizing Depreciation Outside SDIRAs

Hold depreciable assets in taxable accounts to leverage deductions, especially for real estate professionals, offsetting active income (IRS Topic No. 425). SDIRAs are optimal for non-depreciable assets to avoid wasting depreciation benefits.

Diversifying to Avoid UDFI/UBIT

SDIRAs can hold non-depreciable, non-leveraged assets like precious metals or private equity (per IRS Publication 590-A) to avoid UBIT/UDFI.

Custodian Compliance

A passive custodian holding your SDIRA funds ensures compliance with IRS rules, managing Form 990-T filings for UBIT/UDFI and preventing prohibited transactions (IRS Publication 590-B). Transferring a portion of your IRA funds to a passive custodian allows you to maintain exposure to public stocks and bonds with a traditional custodian while earmarking some investing funds for private investments.

Final Thoughts

Investors often mistakenly expect depreciation to enhance SDIRA tax benefits, but depreciation's narrow use inside SDIRAs gives it a limited benefit compared to taxable accounts. Equity real estate can be held in SDIRAs for high-appreciation or low-debt scenarios, but private lending, free of UDFI and depreciation issues, is often a superior choice. With tax-deferred growth in Traditional SDIRAs and tax-free returns in Roth SDIRAs, lending’s high yields and low risk make it ideal. By placing depreciable assets in taxable accounts and non-leveraged loans or select equity real estate in SDIRAs, investors can optimize tax efficiency and achieve financial independence.

We use a combination of strategies in our own early-retirement portfolio, as well as in IRA accounts that we can access after age 59½. We are personally navigating these tax and income implications in our own lives, balancing cash flow and growth across taxable and tax-advantaged accounts to suit our needs at various ages and stages.

For private real estate lending, we pay you 10 or 12% on loans to our trusted network of real estate borrowers. Outside an IRA, this provides a reliable cash flow for our early retired investors. Inside an IRA, this can provide you with a reliable cash flow and lower-risk compounded growth of 15% IRR, ready for you to access in later retirement.

Whichever path or combination of paths you choose, we at Retoro Capital are here to help you get access to high-quality private loans to diversify your portfolio and expand your income streams.