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You've seen the advertisements and news articles. IRA funds can be used to make real estate investments. But before you jump on this bandwagon, make sure you understand some of the tax planning angles related to this opportunity.

Passive Loss Deductions

Almost always, an important component of your real estate profits comes from the tax savings associated with depreciation. These paper losses, referred to as passive losses by the Internal Revenue Code, can save both small and professional real estate investors thousands of dollars a year in income taxes. Unfortunately, passive losses from depreciation and related, similar tax deductions won't benefit real estate investors investing through IRAs.

Capital Gains Preferences

If you sell an investment for a profit'whether a stock or real estate'you get a tax break because your profit gets taxed at a preferential capital gains tax rate. In the best case scenario under current tax law, for example, your capital gains get taxed at 15% rather than at 35%.

Unfortunately, by putting real estate inside of an IRA, you lose this benefit. In effect, the appreciation you enjoy from your real estate investment gets taxed at your marginal income tax rate rather than at the capital gains rate. (Fortunately, the tax gets paid when you withdraw the money.)

Note: This 'problem' also exists for other investments that produce capital gains, such as stocks and mutual funds that invest in stocks.

Unrelated Business Income Tax

In certain special circumstances, an IRA needs to pay income taxes on the profits it generates. These taxes, called unrelated business income taxes, essentially put the IRA investor in the same position as a regular taxable investor.

For example, if you're developing and then flipping properties inside your IRA, you may actually be an active trade or business. And in this case, your real estate investment'even though it's inside an IRA'may be subject to income taxes. (Your IRA custodian is supposed to report your taxable income and tax liability, and then pay the taxes but many don't')

And here's another example of a situation where the unrelated business income tax can trip you up. If you borrow money to invest in real estate'the typical situation in any leveraged real estate investment'the profit you earn on the money you've borrowed is treated as unrelated business income. Accordingly, that profit is subject to unrelated business income tax.

Unrelated business income inside an IRA is taxed according to trust taxation rules, which means that as soon as you've made much money at all, you're taxed at the highest marginal tax rates. Ouch.

Closing Caveats

Real estate is a great investment. And real estate belongs in any investor's portfolio. But you need to think carefully about buying into the idea of using your IRA to make real estate investments. If you do decide to invest in real estate through your IRA, first consult with your tax advisor.