Can SDIRAs Take Depreciation on Owned Real Estate?

Self-directed IRAs (SDIRAs) allow investors to hold unique assets like real estate, often through single-owner LLCs or direct ownership. A common question is whether an SDIRA, as a tax-exempt entity, can benefit from depreciation deductions on residential real estate. The short answer: depreciation generally doesn’t apply to SDIRAs because they don’t pay taxes, but it can help if the SDIRA owes tax on unrelated business taxable income (UBTI) from debt-financed property. Let’s break it down in simple terms, focusing on when and how depreciation matters for self-directed retirement accounts.

What Is Depreciation and How Does It Work?

Depreciation is a tax deduction that lets property owners recover the cost of real estate over time, set at 27.5 years for residential properties and 39 years for non-residential properties under I.R.C. § 168(c). For example, if a property owner has a $275,000 residential rental property, it can deduct $10,000 annually ($275,000 ÷ 27.5 years).* Regular investors, as in non-retirement account investors, could use this to lower their yearly taxes, but SDIRAs face a different situation.

Self-directed retirement accounts are tax-advantaged, with investments being able to grow tax-free (generally). For self-directed accounts holding real estate, this means they do not have a tax liability for rental income or gains from the sale of a property. The basis of the property is still being depreciated, in theory, but since there is typically no tax liability to the retirement account, the depreciation deduction goes unused. However, should the retirement account have acquired the property with debt, the deductions for depreciation return to relevancy.

When Depreciation Matters: UBIT and Debt-Financed Property

Depreciation becomes useful for an SDIRA if it owes tax on unrelated business income (UBIT), especially from debt-financed property (More on UBIT here). If the SDIRA uses a mortgage to buy the property, part of its rental income—called unrelated debt-financed income (UDFI)—is taxable. The SDIRA files Form 990-T and pays tax on this income.

Here’s where depreciation helps: the SDIRA can use the full depreciation deduction to lower the taxable UDFI, reducing the tax bill. For example, if an SDIRA owns a $275,000 residential property (50% debt-financed) earning $20,000 in rent, with $10,000 in depreciation, the net income is $10,000. Half of that ($5,000) is UDFI because of the debt. The SDIRA can use the $10,000 depreciation to offset the $5,000 UDFI on Form 990-T, reducing taxable UBIT to zero, saving about $1,850 in tax (at 37% trust rates).

When the SDIRA sells the residential property, the sale price minus the reduced basis (from depreciation) determines the gain. If the SDIRA’s basis dropped due to depreciation, its gain is higher, and part may be subject to UDFI if the property was debt-financed. In the same example as before, a $275,000 property with $100,000 depreciation (10 years at $10,000/year) has a basis of $175,000. If sold for $350,000, the gain is $175,000. If 50% debt-financed, half ($87,500) is UDFI, costing $32,375 in tax (37%).

While no one likes paying taxes, it is important to illustrate the potential advantage of making this investment through a self-directed retirement account. In the above example, after the 10 year hold period and subsequent sale, the original $137,500 investment (50% of $275,000) would now be worth approximately $380,125, a gain of 276%. (10 yrs x $20k rent income = $200k + $75k profit from sale = $275k - $32,375 sale tax = $242,625 + $137,500 original investment = $380,125, without accounting for YoY rent increases or other expenses).

Conclusion

Should you want to invest in real estate with your self-directed retirement account while using debt to finance the purchase, ensure you have access to a tax professional who is knowledgeable in self-directed retirement accounts or other tax-exempt entities, UBIT/UDFI, and real estate. Through proper planning, a carefully developed strategy can ensure that you maximize any returns from your real estate investments.

*For ease of illustration, land value has not been separated from building value, as land value is not able to be depreciated.