Best way to set up a rental income stream for property I already own - checkbook IRA?

Question

Here's my situation: I'm 41. We bought a home in Dayton, OH in 2018 for $140k, with about 4k to 6k sq ft of livable space (depending on how you count it). There is an old two-story servant's quarters behind the home that is an additional 1400 sq ft, and I want to turn it into 4 one-bedroom small apartments. In my area, these should produce about $25k to $32k in annual rent, with a very high occupancy rate. I estimate the rehab project will cost me ~$50-80k depending on how much sweat equity I put in (a LOT of work is needed). I should be able to cashflow this over a couple years. To be clear, this building was included with the main home in the 2018 sale; it's currently all owned under one deed. It does NOT have a separate address. It's all one address.

My marginal income tax rate is 28.5% so I would like to set things up so that eventually the rental income stream is tax-free under a checkbook Roth IRA LLC. I think I fully understand the limitations and downsides of using a checkbook IRA LLC for real estate, including not allowing disqualified persons (including myself) to do work on the property while it is owned by the LLC.

So here is how I envision making this work.

I would first do the rehab of the property, then sell it in an arms-length transaction, with an appraisal and all of that, to a third party. That third party would agree to lease-option the property to my checkbook Roth IRA LLC. The LLC would make payments back to the third party until it has accumulated enough rental income to buy the property, at which point it will buy it and own it. Or it might take a mortgage out if rates become low enough, and invest the proceeds elsewhere.

I plan to hire a CPA and tax attorney to sort all this out and get it right, but I thought I'd start here to see what people think.

My main questions are:

1. If I do an improvement on part of my home like this, and then sell it to someone, will I owe taxes on the sale? On the one hand, I am selling a part of my home so maybe it would be exempt just like it would be if I sold my entire home. But on the other hand, since I'm spinning off a part of my property, maybe this slice becomes an investment property and I would then owe taxes?
2. If taxes would be owed on the gain from the sale, could I move one or two of my kids' bedrooms into that property (it's literally across the back yard) and have them sleep and play there for two years, so that physical building becomes a primary residence? I would of course have to forgo 2 years of rental income doing this, so it may not be worth it.
3. Is there anything wrong here with my understanding of how the rules work with checkbook IRA LLCs?
4. Is arranging these things this way, so that the rental income becomes tax-free in a Roth, worth it? I believe am willing to deal with the complications of involving a third party and using a checkbook IRA LLC to operate the property. None of that bothers me on its face. But maybe I'm missing a big reason why this would be stupid. I could after all do this in the conventional way and straight line depreciate the property, etc etc, and just pay taxes on the rent. But not only would I pay taxes on the rent, but the income will raise my MAGI and this would eventually put my ability to deduct IRA contributions, or contribute to a Roth IRA, in danger if my household income becomes high enough (I easily could see this happening with starting a rental income stream like this that could grow over time, with future properties etc).

Answer 1

then sell it in an arms-length transaction, with an appraisal and all of that, to a third party. That third party would agree to lease-option the property to my checkbook Roth IRA LLC.

This isn't an arms-length-transaction. There are strings. they must agree to lease option it back to your IRA.

I want to turn it into 4 one-bedroom small apartments.

Will the zoning allow this? Some places would block this or require a zoning exception which would require hearings, and lots of paperwork beyond just building permits.

On the one hand, I am selling a part of my home

Some local governments will not allow you to subdivide the parcel. Even if they allow this you might have to make changes to provide them access to the subdivided parcel.

If I do an improvement on part of my home like this, and then sell it to someone, will I owe taxes on the sale

You may owe taxes. It depends on how the parcel was structured, and how much the value changed for that part of the property.

If there is a mortgage on the original property, the lender will need to know about this. They would have to approve a change to the property used as collateral.