A common self-directed IRA question is, “Can I buy a future retirement home with my IRA?” Yes, you can buy a future retirement home with your IRA, but you need to understand the rules and drawbacks before doing so. First, keep in mind that IRAs can only hold investments and you cannot go buy a residence or second home with your IRA for personal use. However, you can buy an investment property with a self-directed IRA (aka “SDIRA”) that you later distribute from your IRA to your self personally then begin to personally use.
The strategy essentially works in two phases. First, the IRA purchases the property and owns it as an investment until the IRA owner decides to retire. You’ll need to use a SDIRA for this type of investment. Second, upon retirement of the IRA owner (after age 59 ½), the IRA owner distributes the property via a title transfer from the SDIRA to the IRA owner personally and now the IRA owner may use it and benefit from it personally as the asset is outside the IRA. Before proceeding down this path, an SDIRA owner should consider a couple of key issues.
Avoid Prohibited Transactions
The prohibited transaction rules found in IRC Section 4975, which apply to all IRA investments, do not allow the IRA owner or certain family members to have any use or benefit from the property while it is owned by the IRA. The IRA must hold the property strictly for investment. The property may be leased to unrelated third parties, but it cannot be leased or used by the IRA owner or prohibited family members (e.g., spouse, kids, parents, etc.). Only after the property has been distributed from the self-directed IRA to the IRA owner may the IRA owner or family members reside at or benefit from the property.
Distribute the Property Fully Before Personal Use
The property must be distributed from the IRA to the IRA owner before the IRA owner or his/her family may use the property. Distribution of the property from the IRA to the IRA owner is called an “in-kind” distribution, and results in taxes due for traditional IRAs. For traditional IRAs, the custodian of the IRA will require a professional appraisal of the property before allowing the property to be distributed to the IRA owner. The fair market value of the property is then used to set the value of the distribution. For example, if my IRA owned a future retirement home that was appraised at $250,000, upon distribution of this property from my IRA (after age 59 ½) I would receive a 1099-R for $250,000 issued from my IRA custodian to me personally.
Because the tax burden upon distribution can be significant, this strategy is not one without its drawbacks. Some owners will instead take partial distributions of the property over time, holding a portion of the property personally and a portion still in the IRA to spread out the tax consequences of distribution. This can be burdensome though, as it requires appraisals each year to set the fair market valuation when you take a distribution of the property (which is done at fair market value). While this can lessen the tax burden by keeping the IRA owner in lower tax brackets, the IRA owner and his/her family still cannot personally use or benefit from the property until it is entirely distributed from the IRA. Many investors will use an IRA/LLC and will transfer the LLC ownership over time from the IRA to the IRA owner to accomplish distribution.
For Roth IRAs, the distribution of the property will not be taxable as qualified Roth IRA distributions are not subject to tax. For an extensive discussion of the tax consequences of distribution, please refer to IRS Publication 590-B.
Additionally, keep in mind that the IRA owners should wait until after he/she turns 59 ½ before taking the property as a distribution, as there is an early withdrawal penalty of 10% for distributions before age 59 ½.
As stated at the outset of this article, while the strategy is possible, it is not for everyone and certainly is not the easiest to accomplish. As a result, before purchasing a future retirement home with your IRA, self-directed investors should make sure they understand that they cannot have personal use while the property is owned by the IRA and that there are taxes due from traditional accounts when you later take the property as a distribution.
There are 28 trillion dollars in retirement plans in the United States. Do you know that these funds can be invested into your business? Yes, it’s true, IRAs and 401(k)s can be used to invest in start-ups, private companies, real estate, and small businesses. Unfortunately, most entrepreneurs and retirement account owners didn’t even know that retirement accounts can invest in private companies but you’ve been able to do it for over 30 years.
Think of who owns these funds: It’s everyday Americans, it’s your cousin, friend, running partner, neighbor…it’s you. In fact, for many Americans, their retirement account is their largest concentration of invest-able funds. Yet, you’ve never asked anyone to invest in your business with their retirement account. Why not? How much do you think they have in their IRA or old employer 401(k)? How attached do you think they are to those investments? These are the questions that have unlocked hundreds of millions of dollars to be invested in private companies and start-ups.
How Many People Are Doing This?
Recent industry surveys revealed that there are one million retirement accounts that are self-directed into private companies, real estate, venture capital, private equity, hedge funds, start-ups, and other so-called “alternative” investments (e.g. Bitcoin and cryptocurrencies). It is a sliver of the overall retirement account market, but it’s growing in popularity.
So, how does it work? How can these funds be properly invested into your business? If you ask your CPA or lawyer, the typical response is, “It’s possible, but very complicated, so we don’t recommend it.” In other words, they’ve heard of it, but they don’t know how it works, and they don’t want to look bad guessing. If you ask a financial adviser, particularly your own, they’ll talk about how it’s such a bad idea while thinking about how much fees they’ll lose when you stop buying mutual funds, annuities, and stocks that they make commissions or other fees from. Well, not all financial advisers, but unfortunately too many do.
Now, there are some legal and tax issues that need to be complied with, but that’s what good lawyers and accounts are for, right? And yes, there is greater risk in private company or start-up investments so self-directed IRA investors need to conduct adequate due diligence and they shouldn’t invest all of their account into one private company investment. So how does it work?
What is a Self-Directed IRA?
In order to invest into a private company, start-up, or small business, the retirement account holder must have a self-directed IRA? So, what is a self-directed IRA? A self-directed IRA is a retirement account that can be invested into any investment allowed by law. If your account is with a typical IRA or 401(k) company, such as Fidelity, Vanguard, TD Ameritrade, Merrill Lynch, Charles Schwab, then you can only invest in investments allowed under their platform, and these companies deem private company investments as “administratively unfeasible” to hold so they won’t allow your IRA or 401(k) to invest in them (some make exceptions for ultra-high net-worth clients, $50M plus accounts). As a result, the first step when investing in a private company with retirement account funds is to rollover or transfer the funds, without tax consequence, to a self-directed custodian who will allow your IRA, Roth IRA, SEP IRA, HSA, or Solo 401(k) to be invested into a private company. My company, Directed IRA & Directed Trust Company, handles self-directed IRAs and our clients have invested millions in private companies.
Legal Tip: If an investor’s retirement account is with their current employer’s retirement plan (e.g. 401(k)), they won’t be able to change their custodian until they leave that employer or until they reach retirement age (59.5 years old or 55 under some plans). So, for now, they’re 401(k) is usually limited to buying mutual funds they don’t understand and don’t want.
Sell Corporation Stock or LLC Units to Self-Directed IRAs
Are you seeking capital for your business in exchange for stock or other equity? If so, you should consider offering shares or units in your company to retirement account owners. You don’t need to wait until your company is publicly traded to sell ownership to retirement accounts. Here are a few well-known companies who had individuals with self-directed IRAs invest in them before they were publicly traded: Facebook, Staples, Sealy, PayPal, Domino’s, and Yelp, just to name a few.
You can also raise capital for real estate purchases or equipment whereby a promissory note is offered to the IRA investor who acts as lender, and the funds are usually secured by the real estate or equipment being purchased. There are many investment variations available, but the most common is an equity investment purchasing shares or units where the IRA becomes a shareholder or note investment whereby the IRA becomes a lender. Keep in mind, you need to comply with state and federal securities laws when raising money from any investor.
Need to Know #1: Prohibited Transactions
There are two key rules to understand when other people invest their retirement account into your business. First, the tax code restricts an IRA or 401(k) from transacting with the account owner personally or with certain family (e.g. parents, spouse, kids, etc.). This restriction is known as the prohibited transaction rule. See IRC 4975 and IRS Pub 590A. Consequently, if you own a business personally you can’t have your own IRA or your parents IRA invest into your company to buy your stock or LLC units. However, more distant family members such as siblings, cousins, aunts and uncles could move their retirement account funds to a self-directed IRA to invest in your company. And certainly, unrelated third-parties would not be restricted by the prohibited transaction rules from investing in your company. What if you are only one of the founders or partners of a business, and you want to invest your IRA or your spouse’s IRA into the company? This is possible if your ownership and control is below 50%, but this question is very complicated and nuanced, so you’ll want to discuss it with your attorney or CPA who is familiar with this area of the tax law.
If a prohibited transaction occurs, the self-directed IRA is entirely distributed. That’s a pretty harsh consequence and one that makes compliance with this rule critical.
Need to Know #2: UBIT Tax
The second rule to understand is a tax known as Unrelated Business Income Tax (“UBIT”, “UBTI”). UBIT is a tax that can apply to an IRA when it receives “business” income. IRAs and 401(k)s don’t pay tax on the income or gains that go back to the account so long as they receive “investment” income. Investment income would include rental income, capital gain income, dividend income from a c-corp, interest income, and royalty income. If you’ve owned mutual funds or stocks with your retirement account, the income from these investments always falls into one of these “investment” income categories. However, when you go outside of these standardized forms of investment, you can be outside of “investment” income and you just might be receiving “business” income that is subject to the dreaded “unrelated business income tax.” This tax rate is at 37% at about $12,000 of taxable income annually. That’s a hefty rate, so you want to make sure you avoid it or otherwise understand and anticipate it when making investment decisions. The most common situation where a self-directed IRA will become subject to UBIT is when the IRA invests into an operational business selling goods or services who does not pay corporate income tax. For example, let’s say my new business retails goods on-line, and is organized as an LLC and taxed as a partnership. This is a very common form of private business and taxation, but one that will cause UBIT tax for net profits received by self-directed IRA. If, on the other hand, the same new business was a c-corporation and paid corporate tax (that’s what c-corps do), then the profits to the self-directed IRA would be dividend income, a form of investment income, and UBIT would not apply. Consequently, self-directed IRAs should presume that UBIT will apply when they invest into an operational business that is an LLC, but should presume that UBIT will not apply when they invest into an operational business that is a c-corporation.
Legal Tip: IRAs can own c-corporation stock, LLC units, LP interest, but they cannot own s-corporation stock because IRAs and 401(k)s do NOT qualify as s-corporation shareholders.
Now, if you’re an LLC raising capital from other people’s IRAs or 401(k)s, you should have a section in your offering documents that notifies people of potential UBIT tax on their investment. UBIT tax is paid by the retirement account annually on the net profits the account receives so it doesn’t cost the company raising the funds any additional money or tax. It costs the retirement account investor since UBIT is paid by the retirement account. Despite the hefty tax, many IRAs and 401(k)s will still invest when UBIT is present as they may be willing to pay the tax on a well-performing investment or their investment strategy. Alternatively, many self-directed IRAs may be investing with an intent to sell their ownership in the LLC as the mechanism to receive their planned return on investment. When selling their LLC ownership, the gain in the LLC units would be capital gain income and would not be subject to UBIT.
If the investment from the self-directed IRA was via a note or other debt instrument, then the profits to the IRA are simply interest income and that income is always investment income and is not subject to UBIT tax. Many companies raise capital from IRAs for real estate purchases or for equipment purchases. These loans from an IRA or IRA(s) are often secured by the real estate or equipment being purchased and the IRA ends up earning interest income like a private lender.
Summary
So, here’s a brief summary of what we’ve learned. First, there’s $28 trillion in retirement plans in the U.S. These retirement accounts can be used to invest into your start-up or private company. You need to comply with the prohibited transaction rules and you can’t invest your own account or certain family member’s account into your business as that would invalidate the IRA. But everyone else’s IRA can invest into your company. And lastly, depending on how the company is structured (LLC or C-Corp), and how the investment is designed (equity or debt/loan), there may be UBIT tax on the profits from the investment. Remember, UBIT tax usually arises for IRAs in operating businesses structured as LLCs where the company doesn’t pay a corporate tax on their net profits. This income is pushed down to the owners and in the case of an IRA this can cause UBIT tax liability.
Here’s the bottom line, retirement account funds can be a significant source of funding and investment for your business, so it’s worth some time and effort to learn how these funds can most efficiently be utilized. While there are some rules unique to retirement accounts they can easily be understood and planned for.
Every buyer of a small business should consider the following three key legal issues when acquiring a business.
1. Buy Assets and Not Liabilities.
Most small business purchases are done as what are called “Asset Purchases”. In an Asset Purchase the buyer of the business acquires the assets of the business only. The assets include the goodwill, name, equipment, supplies, inventory, customers, etc. According to the terms of a properly drafted Asset Purchase Agreement, the assets do not include the prior owner’s business liabilities (the known or unknown). Under an Asset Purchase the buyer typically establishes a new company which will operate the business. This new company is free from the prior company’s liabilities and actions.
A “Stock Purchase” on the other hand occurs when the buyer acquires the stock or LLC units of the existing business. There are a few downsides to acquiring a business under a stock purchase. First, if you buy the stock or units of an existing company then you get the existing assets AND the existing liabilities of the acquired company. Since a new buyer hasn’t operated the business it is impossible for them to accurately quantify the existing liabilities. The second downside to a Stock Purchase is that the new owner of the company takes the current tax position of the departing owner when it comes to writing off equipment and other items in the company at the time of purchase. The downside to this is that the seller of the business may have already fully written off these items leaving the new business owner with little business assets to depreciate (despite a significant financial investment). If, on the other hand, the buyer acquired the “assets” in an Asset Purchase the buyer would depreciate and expense those assets as the new business owner chooses and in the most aggressive manner possible. Bottom line, an Asset Purchase has less liability risk and has better tax benefits that will allow the buyer to generate better tax write-offs and deductions over the life of the business.
2. Negotiate For Some Seller Financed Terms.
Many small business purchases include some form of seller financed terms whereby the seller agrees to be paid a portion of the purchase price over time via a promissory note. Seller financing terms are excellent for the buyer because they keep the seller interested and motivated in the buyer’s success since business failure typically means that the buyer wont be able to fully pay the seller. If the seller gets all of their money at closing then the seller is typically less interested in helping transition the business to the new owner as the seller has already been paid in full. Also, if the seller misrepresented something in the business during the sale that results in financial loss to the buyer, the buyer can offset the loss or costs incurred by amounts the buyer owes the seller on the note. In sum, the seller financed note gives the buyer some leverage to make sure the value in the business is properly and fairly transferred.
3. Conduct Adequate Due Diligence.
While it may go without saying that a buyer of a business should conduct adequate due diligence, you would be surprised at how many business purchases occur simply based on the statements or e-mails of a seller as opposed to actual tax returns or third party financials showing the financial condition of the business. A few due diligence items to consider are; get copies of the prior tax returns for the company, get copies of third party financials, make the seller complete a due diligence questionnaire where the seller represents the condition of the business to the buyer (similar to what you complete when you sell a house to someone). A lawyer with experience in business transactions can help significantly in conducting the due diligence and in drafting the final documents.
Buying an existing business is not only a significant financial commitment but is also a significant time commitment. Make sure the business is something worth your time and money before you sign. Oh, and make sure you get a well drafted set of purchase documents to sign.
IRAs are the most overlooked opportunity in real estate. Let me explain.
First, there are over 9 Trillion Dollars in IRA accounts in the U.S. This number is staggering and makes IRAs one of the largest sections of investable cash in the world. Source, Investment Company Institute & Federal Reserve Board. But what does this have to do with real estate? Well, contrary to popular belief, IRAs have always been able to invest in and own real estate. They can own single family rentals, or flip properties, or own LLCs that own multi-family or commercial real estate. They can also invest as a private lender on real estate.
At this point in the IRA and real estate conversion. I’m usually asked, why have I never heard of this before? Well, the major providers of IRAs have generally found real estate to be “administratively unfeasible” as it takes more work to handle and administer than a publicly traded stock or REIT does. In other words, the brokerage and insurance firms who administer most IRAs restrict their IRAs to…well…the stuff they sell like publicly traded stock, mutual funds, and annuities. You’ve always been able to own real estate in an IRA but there have been few IRA custodians who allow it and as a result it isn’t as widely known as it should be. This have been changing over the past decades as awareness has spread.
In fact, the only investment assets restricted for IRAs is life insurance, collectible items (e.g. art, antique car), and s-corporation stock. IRC 408(m);IRC 408(a)(3);IRC § 1361 (b)(1)(B).
What Kind of Real Estate Can an IRA Own?
IRAs can own single-family rental properties. IRAs can own properties being flipped for profit. IRAs can invest in small private LLCs that own commercial properties or multi-family properties with other individuals or IRAs. IRAs can own options on real estate. And IRAs can lend money secured to other real estate investors as a private investor or hard money lender. You can’t, however, buy real estate for personal use or for use by certain disqualified family members. The assets owned by your IRA must be held for investment purposes.
In sum, any real estate owned for investment purposes can be owned by an IRA. The law has very few restrictions on assets owned by a retirement account. In fact, the only investment assets restricted for IRAs is life insurance, collectible items (e.g. art, antique car), and s-corporation stock. IRC 408(m);IRC 408(a)(3);IRC § 1361 (b)(1)(B). So all investment real estate is fair game for IRAs.
To own real estate with an IRA, you must establish what is called a self-directed IRA and transfer the funds from your current IRA provider (or prior employer 401(k)) to the “self-directed IRA” provider. There are many companies who offer these types of accounts, like my own company, Directed IRA and Directed Trust Company.
What is a Self-Directed IRA?
A self-directed IRA is an IRA that can invest into any investment allowed by law. Real estate is the most common investment for self-directed IRAs but they can also be invested into start-ups, private equity funds, venture capital funds, precious metals, and even crypto-currency. Let’s focus on real estate though.
There are a few critical issues to consider when buying real estate with an IRA.
The IRA Owns the Property, Not You Personally
Let’s go over a real estate rental or property you plan to flip with the IRA. The purchase contract to buy the real estate must be in the name of the IRA and the deed to the property will be in the name of the IRA. The IRA funds, including the earnest money deposit, will come from the IRA account. Keep in mind, the IRA account owner is not buying the property so the contract should not be in their personal name nor should the IRA owner’s personal funds be used. IRAs are held in the name of the custodian of an IRA. So, for example, if your IRA is with my company, Directed IRA & Directed Trust Company, the titling of your IRA would be Directed Trust Company FBO John Doe IRA. That is the name of the buyer on the contract and is the name on title to the property.
Improvement costs and expenses for the IRA owned property must be paid by your IRA and not personally by the IRA owner. Conversely, when there is rental income on the property or when the property sells for a gain then that income goes back into the IRA. Now, one of the huge perks of investing with an IRA is that there is no tax when the IRA makes money. That works with buying and selling stock for gain as well as buying and selling real estate for gain. Consequently, the rental income and the income when you sell the property is not taxable. If this is a Traditional IRA, then the money comes out tax-deferred at retirement and you pay tax as you draw it out. But if it is a Roth IRA, then money comes out tax-free at retirement…so put your best real estate deals in your Roth IRA. But remember, even the Traditional IRA grows tax-deferred with all income accumulating and growing until retirement.
Avoid Prohibited Transactions
When self-directing your retirement account, you must be aware of the prohibited transaction rules found in IRC 4975. These rules restrict WHOM your account may transact with, not what kind of investment your account may own. In short, the prohibited transaction rules restrict your retirement account from engaging in a transaction with someone who is a disqualified person to your account. A disqualified person to a retirement account includes the account owner, their spouse, children, parents, and certain business partners. So, for example, your retirement account could not buy a rental property that is owned by your father since a purchase of the property would be a transaction with someone who is disqualified to the retirement account (e.g. father). Similarly, you couldn’t buy a rental property from a third-party and then rent to your child as your child is a disqualified person. On the other hand, your retirement account could buy real estate from your cousin, friend, sister, or a third-party, as these parties are not disqualified persons under the rules.
A prohibited transaction can also arise if there is self-dealing where the IRA owner or disqualified family members are personally benefitting or making money from the IRAs investments. For example, if you are a real estate agent/broker and your IRA buys real estate you cannot receive the buyer’s agent commission as that would result in a financial benefit to you personally. You’d have to waive this fee and have the purchase price reduced or have someone else represent the IRA.
If an IRA engages in a prohibited transaction, the entire IRA account involved is deemed distributed and is no longer an IRA. Taxes and possible early withdrawal penalties apply under the normal distribution rules.
Use an IRA Owned LLC (aka, IRA/LLC or checkbook control IRA)
Many self-directed retirement account owners, particularly those buying real estate, use an IRA owned LLC as the vehicle to hold their retirement account assets. Under the IRA/LLC structure, the IRA typically owns the LLC 100% and the LLC in turn owns the real estate So, rather than buying real estate and owning it directly in the IRA custodian’s name, your IRA would invest and own an LLC and the LLC in turn would own the real estate.
The IRA/LLC is typically managed by the IRA owner. Under the structure, the IRA owns all of the membership/ownership units of the LLC but the IRA owner can serve as the manager of the LLC. Manager of an LLC is like the president of a corporation. The manager can sign for the LLC and can act on behalf of the LLC. As manager of the LLC, the IRA owner would establish an LLC bank checking account for the LLC and the IRA funds would be invested and deposited into that LLC business checking account. Because the IRA is funding all the investment dollars into the LLC, the IRA owns 100% of the LLC.
Now, the LLC is funded with the IRA cash and the IRA owner is the manager of the LLC. The IRA owner can decide how much cash to invest into the LLC from the IRA depending on the real estate they are planning to buy with the IRA/LLC. When offers to purchase real estate are made with an IRA/LLC, the LLC is the buyer on the real estate purchase contract and the earnest money deposit and final funds to close on the property would come from the LLC bank checking account. The IRA owner, as manager of the LLC, signs the real estate purchase contract and has control of the LLC bank checking account and can sign checks or send wires for the LLC account. Keep in mind, the LLC is owned 100% by the IRA and the LLC funds cannot be used for personal purposes and cannot be used to pay the IRA owner. If you ever want to take money from the IRA/LLC, you must send money from the LLC bank account back to the IRA (since the IRA owns the LLC) and you then take a distribution from the IRA.
And lastly, the IRA/LLC docs are unique and most contain IRA provisions in the LLC operating agreement and subscription sections. As a result, you should use a lawyer who is familiar with IRA/LLCs as many IRA custodians who allow for IRA/LLCs require an attorney or CPA to sign off on the docs. My law firm, KKOS Lawyers, has been drafting IRA/LLCs for over 12 years and charges a flat fee of $800 plus state filing fees. There are more complex IRA/LLC structures that involve multiple IRAs (e.g. spouses or other investors) and or combinations of IRAs and individuals and those structures are called Multi-Member IRA/LLCs and typically cost more to set-up.
How to Properly Get a Mortgage Loan With Your IRA?
Your IRA, or IRA/LLC, can get a mortgage loan when you buy real estate, but you need to know two things before you do.
First, the loan must be non-recourse to the IRA owner as the rules regarding IRAs do not allow the IRA owner to personally be responsible for the loan or to personally extend credit to the IRA. Under a non-recourse loan, the bank lends money to the IRA, or IRA/LLC, and gets a deed of trust or mortgage against the property securing the loan. In the event of default, the lender can foreclose and take the property back but cannot go after the IRA or the IRA owner for any deficiency in the loan. Because the lender’s ability to collect is limited to the property they loaned on, the banks who lend to IRAs require 30-40% down. There are several banks who specialize in these non-recourse loans to IRAs and an IRA owner is best served by using a bank or private lender who routinely provides these type of non-recourse loans.
Second, there is a tax called unrelated debt financed income tax (“UDFI”) that applies to an IRA when the IRA leverages its investment dollars with debt. Essentially, the IRS will tax the income from the debt invested while leaving the percent of the deal attributed to the IRAs cash investment not subject to tax. So, for example, let’s say your IRA bought a rental property for $100k with the IRA putting $40k cash down and getting a non-recourse loan for $60k. To the IRS, 40% of this deal is the IRA funds and 40% of the income is not subject to tax while the other 60% is non-IRA funds and that 60% is subject to tax. The tax on this 60% is UDFI tax. The tax rate on UDFI is the trust tax rates which maxes out at 34% on rental income. This is after expenses of course; which expenses include depreciation.
Upon the sale of the property, the IRS allows you to use the capital gains tax rate for the UDFI tax so you can move down from the 34% rate to the max long-term capital gains rate of 20%. Now technically, UDFI is a form of UBIT tax discussed below. But it applies in a very different way, when there is debt, so I explain it separately.
Many self-directed IRA investors will only buy real estate with cash in their IRA and won’t bother with a non-recourse loan and the UDFI tax burden while others view the UDFI tax as a cost of doing business and see debt as a tool to buy more property and thereby increase overall returns. Keep in mind, UDFI tax is only due on net rental income or net gain upon sale and this is after property expenses and depreciation expense.
Watch Out for Unrelated Business Income Tax (UBIT)?
There is a tax that can apply to an IRA’s income called unrelated business income tax (“UBIT”). Usually, when we think of IRAs, we aren’t expecting there to be taxes on the income and this is typically the case. However, there are a few situations where IRAs will have to pay tax on the income they make. These tax situations arise when the income being made is considered “business income” (aka, ordinary income) as opposed to investment income. Most real estate income is automatically exempt from UBIT. Exempt income from UBIT includes rental real estate income, capital gain income when you sell real estate, and interest income when you lend money on real estate. IRC 512. So let’s go over the common situations where UBIT tax is generally due.
First, there is the instance of debt mentioned above which causes UDFI. UDFI is a form of UBIT and applies to the profits attributable to the debt involved.
Second, if the IRA is doing real estate development activities, or is otherwise invested in real estate projects that create ordinary income it will need to pay UBIT tax on the profits. Real estate development income that is ordinary income in nature, as opposed to long-term capital gain, will cause UBIT for the IRA. It is possible to do real estate development with an IRA and hold the property for investment purposes. If a real estate development was done and the property held for investment, then the IRA would avoid UBIT tax. That being said, you should carefully consult with your tax lawyer or CPA on the details of your strategy and whether UBIT would apply.
The last situation where UBIT can apply is when you flip multiple properties with your IRA in a year. Since most fix and flip transactions are short-term in nature (under one-year hold time), IRA owners need to be careful not to do too many flips with their IRA in one year as the IRA can be deemed to be in the business of real estate. If the IRA is deemed to be in the business of real estate, then the income the IRA makes from the flips will be subject to UBIT. If the IRA is flipping one or two properties a year you don’t need to worry about the IRA being deemed in the business of real estate. However, if the IRA is flipping more a couple properties a year you should consult you tax lawyer or CPA on the exact details of your IRAs investments.
If your IRA is subject to UBIT, then the IRA files its own separate tax return called a 990-T and the IRA pays the tax due. This return is separate from the IRA owner’s personal tax return. The 990-T is the responsibility of the IRA owner and is not something that is generally prepared by your self-directed IRA custodian. You’ll need to engage a tax lawyer, CPA, or accountant to prepare and file the 990-T. Or you can complete it on your own, but it is a very technical return and there is little guidance on how it should be prepared for an IRA.
Summary
These rules can seem a little foreign and overwhelming at first. But I like to say that learning how to self-direct your IRA is like learning a new board game. It’s not that the board game rules are complicated. Rather, it is something you need to learn first before playing and moving pieces. When we play a new board game, we first read the rule book, or we play with someone who already knows the game. So, like playing a board game, read up on the subject and consider my book, The Self-Directed IRA Handbook, or play the game with others who knows the rules (e.g., a lawyer, CPA, advisor, or other investor). After you’ve properly self-directed your IRA into real estate once, you’ll have the rules down and it’s the same game each time thereafter…at least until Congress changes the rules of the game. And if they do, I’ll update my rulebook.
Every Roth IRA account owner knows that the main benefit of the Roth IRA is that there are no taxes due on withdrawals taken after the account owner is 59 ½. However, what taxes or penalties apply to distributions taken before the Roth IRA owner reaches 59 ½?
Roth IRA distributions before age 59 ½ are broken into two categories, contributions and earnings.
Contributions Can Be Withdrawn Before 59 ½ Without Tax or Penalty
The first first category is Roth IRA contributions. This category is distinct because these amounts have been subject to tax before the funds were included in the Roth IRA. The amounts withdrawn from a Roth IRA that do not exceed the amounts of Roth IRA contributions are not subject to taxes or penalties upon early distribution from the Roth IRA. However, any amounts distributed in excess of the Roth IRA contributions, which would typically be the investment returns, are subject to taxes and the early withdrawal penalty of 10%.
This is an excellent perk as it allows Roth IRA owners to take money back that they contributed to the Roth IRA without worrying about penalties or taxes.
Earnings Are Subject to Tax the 10% Early Withdrawal Penalty
Amounts withdrawn before 59 ½ that comprise the Roth IRA’s earnings are subject to tax and a 10% early withdrawal penalty. IRC § 408A(d)(2)(A) & Treasury Reg. §1.408A-6, Q&A-1(b). “Earnings” is the amount over the sums you have contributed to the Roth IRA, and is essentially your investment returns and gains.
Since there are taxes AND penalties on the earnings, you should only take distributions when absolutely necessary.
Example of Roth IRA Distribution Before 59 ½
For example, let’s say a Roth IRA owner is 45 and has a Roth IRA with $65,000. This balance consists of $35,000 in Roth IRA contributions and $30,000 in earnings or investment returns. If the Roth IRA owner took a distribution of the entire account then $35,000 would NOT be subject to early withdrawal penalties as this amount comprised Roth IRA contributions where taxes have been paid already. However, the remaining $30,000 distributed represents investment returns/gains made in the Roth IRA and would be subject to early withdrawal penalties of 10% and must be also be included in the taxable income of the Roth IRA owner. As a result, Roth IRA owners under age 59 ½ should avoid distributions of their Roth IRA in excess of their contributions.
Roth IRAs can be established and funded for high-income earners by using what is known as the “back door” Roth IRA contribution method. Many high-income earners believe that they can’t contribute to a Roth IRA because they make too much money and/or because they participate in a company 401(k) plan. Fortunately, this isn’t true.
While direct contributions to a Roth IRA are limited to taxpayers with income in excess of $120,000 ($189,000 for married taxpayers), those whose income exceeds these amounts may make annual contributions to a non-deductible Traditional IRA and then convert those amounts over to a Roth IRA. Our IRA company – Directed IRA – can help those who want a self-directed “back door” Roth IRA, but the strategy can be done with almost anyone who wants a Roth IRA.
Examples
Here’s a few examples of earners who can establish and fund a Roth IRA:
“I’m a high-income earner and work for a company who offers a company 401(k) plan. I contribute the maximum amount to that plan each year. Can I establish and fund a Roth IRA?” Yes, even though you are high-income, and even though you participate in a company 401(k) plan, you can establish and fund a Roth IRA. You just have to use the “back door” method.
“I’m self-employed and earn over $200,000 a year; can I have a Roth IRA? Isn’t my income too high?” Yes, you can contribute to a Roth IRA despite having income that exceeds the Roth IRA income contribution limits of $189,000 for married taxpayers and $120,000 for single taxpayers. You just have to use the “back door” method.
The Process
The strategy used by high-income earners to make Roth IRA contributions involves the deposit of non-deductible contributions to a Traditional IRA, and then converting those funds in the non-deductible Traditional IRA to a Roth IRA. This is often times referred to as a “back door” Roth IRA. In the end, you don’t get a tax deduction on the amounts contributed, but the funds are held in a Roth IRA and are tax-free upon retirement (just like a Roth IRA). Here’s how it works:
Step 1: Fund a new non-deductible Traditional IRA.
This IRA is “non-deductible” because high-income earners who participate in a company retirement plan (or who has a spouse who does) can’t also make “deductible” contributions to an IRA. However, the account can be funded by non-deductible amounts up to the IRA annual contribution amounts of $5,500 for 2018 ($6,000 for 2019 and forward). The non-deductible contributions mean you don’t get a tax deduction on the amounts contributed to the Traditional IRA. Don’t worry about having non-deductible contributions though, as you’re converting to a Roth IRA, so you don’t want a deduction for the funds contributed. If you did get a deduction for the contribution, you’d have to pay taxes on the amounts later converted to Roth. You’ll need to file IRS form 8606 for the tax year in which you made the non-deductible IRA contributions. The form can be found here.
If you’re a high-income earner and you don’t have a company-based retirement plan (or a spouse with one), then you simply establish a standard deductible Traditional IRA, as there is no high-income contribution limit on Traditional IRAs when you don’t participate in a company plan.
Step 2: Convert the non-deductible Traditional IRA funds to a Roth IRA.
In 2010, the limitations on Roth IRA conversions, which previously restricted Roth IRA conversions for high-income earners, was removed. As a result, all taxpayers are able to covert traditional IRA funds to Roth IRAs since 2010. It was in 2010 that this “back door” Roth IRA contribution strategy was first utilized as it relied on the ability to convert funds from Traditional to Roth. It has been used by tens of thousands of Americans since.
If you have other existing Traditional IRAs, then the tax treatment of your conversion to Roth becomes a little more complicated as you must take into account those existing IRA funds when undertaking a conversion (including SEP and SIMPLE IRAs). If the only IRA you have is the non-deductible IRA, then the conversion is easy because you convert the entire non-deductible IRA amount over to Roth with no tax on the conversion. Remember, you didn’t get a deduction into the non-deductible Traditional IRA so there is not tax to apply on conversions. On the other hand, if you have an existing IRA with $95,000, and you have $5,000 in non-deductible Traditional IRA contributions in another account that you wish to convert to Roth, then the IRS requires you to convert your IRA funds in equal parts deductible (the $95K bucket) and non-deductible amounts (the new $5k) based on the money you have in all Traditional IRAs. So, if you wanted to convert $10,000, then you’d have to convert $9,500 (95%) of your deductible bucket, which portion of conversion is subject to tax, and $500 of you non-deductible bucket, which isn’t subject to tax upon once converted. Consequently, the “back door” Roth IRA isn’t well suited when you have existing Traditional IRAs that contain deductible contributions and earnings from those sums.
There are two workarounds to this Roth IRA conversion problem, and both revolve around moving the existing Traditional IRA funds into a 401(k) or other employer-based plan as employer plan funds are not considered when determining what portions of the Traditional IRAs are subject to tax on conversion (the deductible and the non-deductible). If you participate in an existing company 401(k) plan, then you may rollover your Traditional IRA funds into that 401(k) plan. Most 401(k) plans allow for this rollover from IRA to 401(k), so long as you are still employed by that company. If you are self-employed, you may establish a Solo or owner-only 401(k) plan, and rollover your Traditional IRA into this 401(k). In the end though, if you can’t roll out existing Traditional IRA funds into a 401(k), then the “back door” Roth IRA is going to cause some tax repercussions, as you also have to convert a portion of the existing Traditional IRA funds, which will cause taxes upon conversion. Taxes on conversion aren’t “the end of the world” though, as all of the money that comes out of that Traditional IRA would be subject to tax at some point in time. The only issue is it causes a big tax bill, so plan carefully.
The bottom line is that Roth IRAs can be established and funded by high-income earners. Don’t consider yourself “left out” on one of the greatest tax strategies offered to Americans: The Roth IRA.
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The "Self Directed IRA Handbook" by attorney Mat Sorensen is the most comprehensive book ever written about one of the best investment and retirement savings tools ever created: the Self-Directed IRA. Mat has performed the impossible by effectively delivering complex information in an easily understandable manner for the layperson, while providing the necessary legal basis to suit the professional. Mat's book is a "must read" for investors, attorneys, CPAs, and other professionals and other interested individuals wanting to learn about all there is to know about Self-Directed IRAs.
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Mat is truly an expert on self directed IRAs, and his book is the one book that every self directed IRA investor should read.
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Mathew is the legal partner for the majority of my clients. Matthew provides solid legal advice, precise strategic planning, appropriate corporate structure development, and is readily available to consult with his clients on all legal and business manners. Matthew is well respected and has an extremely large network in the successful real estate investor world. Matthew is reliable, professional and an all around great partner to have on your side
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My wife and I recently sought Mat's help with estate planning and couldn't have been more satisfied. Mat's professionalism, honesty, creativity and attention to detail is second to none. What impresses me the most about Mat can be summed up as "diverse". Mat's vast knowledge and experience in a plethora of differing areas of the law is astounding. I highly recommend Mat to my clients and friends seeking legal help.
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Mat is a highly qualified...lawyer specializing in real estate. He's personable and professional, knows his stuff and is a nice guy. It doesn't get any better than that. I really liked the way he explained everything to me at my level so I got it. He also advised the best way for me to proceed with my RE investments. He handled my case in a timely manner with high integrity.
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Gary Shumm
Mathew is an excellent attorney, well versed in the Self-Directed IRA market…His ability to distil the complexities of the Self-Directed IRA so that the average person can understand them, and ensure that they don't get "tripped up" is second to none. Anyone interested in this Self-Directed IRA Market would do well to connect with Mathew and learn from the best.
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Mat is truly an expert on self directed IRAs, and his book is the one book that every self directed IRA investor should read.
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Kaaren Hall
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"Mat's book is an excellent resource for self directed IRA owners and their advisors. It is the first of its kind in our industry. Mat has truly written an“Authoritative Guide” for self directed IRAs."
Pamela Constantino
President / Polycomp Trust Company
"Mat is an excellent attorney, well versed in the Self-Directed IRA market...His ability to distill the complexities of the Self-Directed IRA so that the average person can understand them, and ensure that they don't get "tripped up" is second to none.
Gary Shumm
Vice President / IRA Services Trust Company
"Mat’s book is the most practical and comprehensive self directed IRA guide in our industry. Reading this handbook should be the first step for any alternative asset investor, investment sponsor, or trusted advisor that seeks to become informed about how to maximize the value of IRAs."
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"Mat's books is a great reference guide for self-directed IRA investing – Best I’ve seen in 30 years of being in the business."
Harry Veldkamp
CEO / Polycomp Trust Company
"The Self Directed IRA Handbook by attorney Mat Sorensen is the most comprehensive book ever written about one of the best investment and retirement savings tools ever created: the Self-Directed IRA."
Tom Anderson
Founder and Retired CEO, PENSCO Trust Company
J.P. Dahdah
Mat’s book is the most practical and comprehensive self directed IRA guide in our industry. Reading this handbook should be the first step for any alternative asset investor, investment sponsor, or trusted advisor that seeks to become informed about how to maximize the value of IRAs.
A common self-directed IRA question is, “Can I buy a future retirement home with my IRA?” Yes, you can buy a future retirement home with your IRA, but you need to understand the rules and drawbacks before doing so. First, keep in mind that IRAs can only hold investments and you cannot go buy a residence or second home with your IRA for personal use. However, you can buy an investment property with a self-directed IRA (aka “SDIRA”) that you later distribute from your IRA to your self personally then begin to personally use.
