Using A Roth To Clear Capital Gains

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An idea popped into my head today, which I cannot shake. I am hoping that someone would tell me I’m an idiot, but it looks right to me.

There are a million ways to structure this, but I’ll go with one that appears to be the cleanest.

Let’s say I bought a rehab for 40K. I put 40K into it and it now appraises at 100K. My basis on this property is 80K. I can now sell this property for whatever I want, 80k, 85k, 100k, 1MM, it really doesn’t matter, the IRS just wants capital gains on the amount over the 80K.

Now let’s say that I have a self-directed Roth IRA. The IRA can be used for purchasing real estate, notes, etc. and the profits get rolled into the IRA and can come out tax-free later.

So, what would stop me from using the above example of the rehab, spending the 80k myself, and to make this whole thing look even easier, I get it appraised for 100K, do an 80% LTV refi on the property and recover my money out of the deal. Now I have a lender in 1st position. I then sell my Roth IRA a note in second position for the remaining 20% equity for $1.

Now if I sold the property for 100K (could be today, could be 5 years from now), I would get $80,001 and the Roth would get $19,999 tax-free. I would pay a capital gain on the $1 (for purposes of simplicity, I left out closing costs, etc).

I know that it looks like I am selling a 20K note for $1 and that should throw up flags, but there is nothing stopping me from buying non-performing notes for pennies on the dollar, and If they begin to perform, it is the same scenario. Even if $1 is too cheap, then why not $2000 for the note, that’s 10%? Since I can sell my position in my home for whatever I want to whomever I want, couldn’t I just sell it to my IRA and in essence bypass the tax man?

Go ahead now, tell me I’m a moron, I can take it.

Comments(2)

  • DaveT29th January, 2004

    Maybe I did not follow the intricacies very well, but I see it thus.

    When you decide to give your IRA a note for $20K all you have done is place a lien on your property with the IRA as the holder of the note. You are still the mortgagor, and at settlement (when you sell this property for $100K), you will get $100K. You use the first $80K to pay off the lender who holds the note in first position, then you use the remaining $20K to redeem the second position held note by your IRA (actually all this is done for you by the settlement attorney, but you still get credit for the sale proceeds on the HUD-1).

    Your taxable profit on the deal is still $20K, you just won't have any of the money in your hands after the dust clears.
    [ Edited by DaveT on Date 01/29/2004 ]

  • gprint29th January, 2004

    "I then sell my Roth IRA a note in second position for the remaining 20% equity for $1"

    Whether $1 or $20K I believe the IRS may see this as "self dealing" and therefore a prohibited transaction.

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