Key Points 

• Capital gains tax usually applies when selling a capital asset for a profit.
• Self-Directed IRAs (SDIRAs) and Self-Directed Solo 401(k)s can help avoid immediate capital gains taxes on alternative assets.
• Leverage is common in many SDIRA investments but can be subject to an additional tax called UBIT.

Self-Directed IRAs (SDIRAs) offer exciting investment opportunities and appealing tax advantages for investors of all experience levels. Although standard IRA investments benefit from similar tax treatment, they typically limit your choices to Wall Street products such as stocks, bonds, and mutual funds. 

With an SDIRA, you can expand your retirement portfolio with alternative assets such as real estate, private placements, and more. If you invest in these assets with personal funds, you would pay capital gains tax upon any sale of an asset. However, when you invest through the structure of an SDIRA, any capital gains are either tax-free or tax-deferred. Here's how Self-Directed IRAs interact with capital gains tax.

What Is Capital Gains Tax?

The IRS levies capital gains tax when you sell a capital asset such as a stock, mutual fund, or real property for a profit. Capital gains are categorized into short-term or long-term gains, which will affect the tax rate applied. Short-term capital gains apply to assets held for one year or less and are taxed at the same rate as your ordinary income, which can be as high as 37%. On the other hand, long-term capital gains, which apply to assets held for more than one year, benefit from reduced tax rates, starting as low as 0% and not exceeding 20% for most taxpayers.

The determination of your specific capital gains tax rate also hinges on your taxable income bracket. For instance, individuals with a lower income may qualify for a 0% long-term capital gains tax rate, offering a potential incentive for holding onto investments for more than a year. Conversely, those in the highest income brackets could face long-term rates up to 20% (still a substantial saving compared to the rate for short-term gains).

Certain exceptions and exclusions can apply to potentially reduce your capital gains tax liability. For example, the sale of your primary residence may qualify for an exclusion if you meet specific criteria. Additionally, tax laws are subject to change, and various deductions or credits may apply depending on the nature of the asset and the investment vehicle used.

SDIRAs and Capital Gains Treatment

If you were to sell a capital asset outside of an SDIRA, the profits would be subject to capital gains tax. With an SDIRA, however, any gains would receive shelter from current taxes. For example, if you invest with a Real Estate IRA (another term for a Self-Directed IRA focused on holding various real estate assets), profit from any sale of a property held in your IRA will not be subject to immediate capital gains taxes. 

An SDIRA is particularly advantageous for investors focusing on long-term growth of alternative assets, as it allows the capital gains to potentially compound tax-deferred or even tax-free, depending on the type of IRA. For Self-Directed Traditional IRAs, the deferred taxation means that any gains from the sale of assets within the IRA will not be taxed until distributions are taken, typically during retirement. This deferral can significantly enhance the growth potential of your investments by allowing the full amount of the proceeds to be reinvested rather than being diminished by taxes in the year of the sale.

For Self-Directed Roth SDIRAs, the advantage is possibly even more pronounced, as investments grow tax-free, and qualified distributions are not subject to taxes. A Roth IRA can provide a potential path to maximizing investment returns without the immediate burden of capital gains taxes. Some investors use this strategy to invest in real estate, while others gravitate to different assets such as cryptocurrency.

What Is a Checkbook IRA?

Self-Directed IRAs can also offer checkbook control for added convenience. These Checkbook IRAs operate as IRA LLCs or IRA Trusts. With a dedicated entity and checking account for your SDIRA investments, you can write checks and send wires for everyday investment transactions in real time. Checkbook Control IRAs mitigate capital gains tax in the same way as regular SDIRAs. Traditional Checkbook IRAs receive tax-deferred advantages, and Roth Checkbook IRAs can accumulate gains tax-free.

Leverage and Taxes 

Many SDIRA investments require large amounts of capital, and real estate tends to be especially capital-intensive. In this scenario, SDIRA owners often use leverage by financing a purchase with a non-recourse loan. With a non-recourse loan, the lender can only pursue the IRA's assets for repayment, safeguarding the investor’s other assets.

It’s important to note that any income generated from the leveraged portion of your investments is considered Unrelated Debt Financed Income (UDFI). The income attributed to the financed amount of your investment would be subject to an additional tax called the Unrelated Business Income Tax (UBIT).

For instance, let's say your IRA LLC purchases a rental property for $100,000, and you put down $50,000 and get a non-recourse loan for the rest. If you receive $2,000 monthly rent, half of that amount would be subject to UBIT because you financed 50%.

Self-employed individuals who opt for a Self-Directed Solo 401(k) enjoy a distinctive advantage when it comes to leveraging investments. These Solo 401(k) plans, tailored specifically for small business owners without full-time W-2 employees, offer the same opportunities as SDIRAs to invest in a wide range of alternative assets. However, a key difference lies in their exemption from UBIT on leveraged real estate investments. The exemption provides a substantial benefit, allowing for the use of leverage without incurring the additional tax burden that comes with UBIT. This makes the Solo 401(k) an appealing option for self-employed investors looking to maximize their investment potential while minimizing tax liabilities.

Speak with a Broad Financial Specialist  

Embracing the advantages of investing with a Self-Directed IRA to navigate around capital gains tax can help enhance your retirement savings potential. Whether you're interested in a Checkbook IRA that offers unparalleled control over your investments or a Solo 401(k) designed to optimize your tax benefits, Broad Financial is here to support your journey.

Ready to take the next step? With our team, you can set up a Checkbook IRA or Solo 401(k) with expert guidance along the way. Contact us today!