When it comes to transferring property, such as rental properties into LLCs or your personal residence into a Trust, it can be confusing understanding whether you should use a quitclaim deed or a warranty deed. Here is a brief description of each type of deed and when they should be used.
Warranty Deed – A warranty deed transfers ownership and explicitly promises the buyer that the transferor has clear title to the property, meaning it is free of liens or claims of ownership. The terms of a warranty deed should state that the transferor “warrants” and conveys the property. The warranty deed may make other promises as well, to address particular problems with the transaction. But generally, the use of the word “warrant” means that seller/transferor guarantees the new owner as to clear title. Because the seller “warrants” clear title under a warranty deed, it is a preferred method of title transfer and should be used by real estate investors and property owners as the default method of transferring title. When transferring title from your own name to your LLC or Trust, the use of a warranty deed typically allows the title insurance you bought when you acquired the property to remain in effect.
Quitclaim Deed – A quitclaim deed transfers whatever ownership interest a person has in a property. It makes no guarantees about the extent of the person’s interest. If you are buying a property from a third-party, you would never want to use a quitclaim deed because they aren’t making any guarantee as to whether they own it or not, or if they have clear title. It would be like paying someone on the street for a set of keys to a car. Who knows whether they own the car or not? You gave them money for it, and if they do own it, you just bought it. But, if they don’t own it, then you’re out of luck and you’ll have to resolve the ownership issue with the person who legally owns it. There are limited situations where a quitclaim deed is used. In some instances, a quitclaim deed is used when the buyer and seller are aware of legal issues or defects to title, so the seller transfers their interest and the new buyer has to resolve the title issues. Another situation, perhaps more common, arises in states that have a transfer tax. For example, some states will exempt transfer taxes on the transfer of title from the owner to their own LLC, but only if it is by quitclaim deed (e.g. Tennessee). When transferring title to your own LLC, we generally aren’t worried about title issues, so the savings on transfer taxes make the quitclaim deed a better option.
Most states don’t have a transfer tax, but to make matters more complicated, some states use the term “grant deed”, California being one of the most prominent. The reality is that a grant deed can be used as a quitclaim deed OR a warranty deed. It essentially depends on the verbiage used inside the terms of the deed itself. If you see words like “warrant” and “convey,” then you probably have a warranty deed. Bottom line: Make sure that you look at the language used in the deed itself. Don’t think that because you have a grant deed you have all of the benefits of a warranty deed.
Our Recommendation – Always double check the local state and county laws regarding the type of deed to use when transferring property, and what the different types of deeds actually provide. HOWEVER, as a general rule of thumb, we recommend the warranty deed when transferring property to yourself, your trust, or your own company because we want to make sure that the Title Policy and all of its benefits transfer to the Grantee of your deed.
Unrelated Business Income Tax (“UBIT”) is often misunderstood by self-directed IRA investors and their professional advisors. In essence, UBIT is a tax that is due to an IRA when it receives “business income” as opposed to “investment income”. When we think of IRAs and retirement accounts, we think of them as receiving income without having to pay tax when the income is made. For example, when your IRA sells stock for a profit and that profit goes back to your IRA you don’t pay any tax on the gain. Similarly, when you sell real estate owned by your IRA for a profit and that profit goes back to your IRA, you don’t pay any tax on the gain. The reason for this is because the gain from the sale of an investment asset is deemed investment income and as a result it is exempt for UBIT tax.
Tip 1, When Does UBIT Apply?
UBIT applies when your IRA receives “unrelated business income”. However, if your IRA receives investment income, then that income is exempt from UBIT tax. Investment income that is exempt from UBIT includes the following.
INVESTMENT INCOME EXEMPT FROM UBIT
- Real Estate Rental Income, IRC 512(b)(3) – The rent of real estate is investment income and is exempt from UBIT
- Interest Income, IRC 512(b)(1) – Interest and points made from the lending of money is investment income and is exempt from UBIT.
- Capital Gain Income, IRC 512(b)(5) – The sale, exchange, or disposition of assets is investment income and is exempt from UBIT.
- Dividend Income, IRC 512(b)(1) – Dividend income from a c-corp where the company paid corporate tax is investment income and exempt from UBIT.
- Royalty Income, IRC 512(b)(2) – Royalty income derived from intangible property rights such as intellectual property and from oil/gas and mineral leasing activities is investment income and is exempt from UBIT.
There are two common areas where self-directed IRA investors run into UBIT issues and are outside of the exemptions outlined above. The first occurs when an IRA invests and buys LLC ownership in an operating business (e.g. sells goods or services) that is structured as a pass-thru entity for taxes (e.g. partnership) and that that does not pay corporate taxes. The income from the LLC flows to its owners and would be ordinary income. If the company has net taxable income it will flow down to the IRA as ordinary income on the k-1 and this will cause tax to the IRA as this will be business income and it does not fit into one of the investment income exemptions.
The second problematic area is when IRAs engage in real estate investment that do not result in investment income. For example, real estate development or a number of significant short-term real estate flips by an IRA will cause the assets of the IRA to be considered as inventory as opposed to investment assets and this will cause UBIT tax to the IRA.
Tip 2, UBIT Applies When You Have Debt (UDFI) Leveraging an IRA Investment
UBIT also applies to an IRA when it leverages its purchasing power with debt. If an IRA uses debt to buy an investment, then the income attributable to the debt is subject to UBIT. This income is referred to as unrelated debt financed income (UDFI) and it causes UBIT. The most common situation occurs when an IRA buys real estate with a non-recourse loan. For example, lets say an IRA buys a rental property for $100,000 and that $40,000 came from the IRA and $60,000 came form a non-recourse loan. The property is thus 60% leveraged and as a result, 60% of the income is not a result of the IRAs investment but the result of the debt invested. Because of this debt, that is not retirement plan money, the IRS requires tax to be paid on 60% of the income. So, if there is $10K of rental income on the property then $6K would be UDFI and would be subject to UBIT taxes.
For a more detailed outline on UDFI, please refer to my free one-hour webinar here.
Tip 3, UBIT Tax is Reported and Paid by the IRA via a Form 990-T Tax Return
Unrelated business income tax (UBIT) for an IRA is reported and paid via IRS Form 990-T. IRS Form 990-T is due for IRAs on April 15th of each year. IRA owner’s can file and obtain an automatic 3-month extension with the IRS by filing an extension request before the regular deadline.
If UBIT Tax is due, it is paid from the IRA and the IRA owner would send the prepared Form 990-T to their IRA custodian for their signature and for direction of payment to the IRS for any tax due as part of the 990-T Return.
For a more detailed outline of UBIT, please refer to Chapter 15 of The Self Directed IRA Handbook.
The most common asset class for self-directed IRA accounts is real estate. Real estate investments for self-directed IRAs come in various forms from simple single-family rentals owned 100% by the IRA to LLC or LP investment partnerships with multiple investors in larger commercial or multi-family properties.
Given the changes in federal securities laws that now allow investment sponsors and real estate syndicators to raise capital more easily, many self directed IRA investors have considered investing their IRAs into these offerings. Crowdfunding sites such as Realcrowd are already offering Crowdfunding type investment opportunities for investors under SEC Rule 506(c). This rule and those investments are currently only available to accredited investors and have no restriction on the investment amount that may come from the accredited investor. These offerings have traditionally been known as private placements or “PPMs” but can now be marketed and there is no requirement that they be “private” so long as the offering company only accepts accredited investors.
For those who are not accredited investors, “true” Crowdfunding under Title III of the JOBS Act goes into effect in May of 2016. Under these Crowdfunding offerings everyone will be able to invest into Crowdfunding opportunities and the investment amount will be based on the investor’s income and assets. These new Crowdfunding rules were enacted in Title III of the JOBS Act and were put into final regulations by the SEC in late 2015.
Before investing your self-directed IRA into a real estate Crowdfunding offering, you must first learn and understand one very important tax called UBIT tax that may apply to your self-directed IRA’s income.
Will My IRA Be Subject to UBIT Tax?
Unrelated Business Income Tax (“UBIT”) applies to an IRA that receives non-passive income. UBIT is a hefty tax and has a maximum rate of 39.6%. IRC § 511. The tax table is copied below.
2016 UBIT Tax Rates
| If taxable income is:||The tax is:|
|Not over $2550||15% of the taxable income|
|Over $2550 but not over $5950||$375 plus 25% of the excess over $2550|
|Over $5950 but not over $9050||$1225 plus 28% of the excess over $5950|
|Over $9050 but not over $12300||$2107 plus 33% of the excess over $9050|
|Over $12400||$3179 plus 39.6% of the excess over $12400|
Although not shown on the table, the first $1,000 in UBIT gross income is exempt and you receive an automatic $1,000 deduction.
UBIT will apply to your self-directed IRAs real estate investment in two scenarios. First, it will apply if the income to the IRA is ordinary. And second, it will apply if the offering company uses debt to acquire its properties.
Does UBIT Apply, Step 1: Is the income passive?
First, UBIT will apply if the investment is an ordinary income producing business. An ordinary income business in real estate investing would include investing into an LLC or LP that conducts new construction, real estate developments held for sale, or other activities that are deemed business activities. Passive income investments, on the other hand, are specifically exempt from UBIT and include real estate rental income, capital gain income, interest income, and dividend income from a c-corp. IRC § 512(b). The vast majority of real estate Crowdfunding offerings are structured to obtain passive income such as rental income while the property is held and capital gain income when the property is sold. Typical real estate offerings where UBIT can be due include offerings to fix and flip properties or offerings for new construction or real estate development where the investment strategy is to buy properties to then immediately sale.
If you have an investment offering that is ordinary income (e.g. a fix and flip fund), then the income to the IRA from the fund will be subject to UBIT tax and the IRA will be required to file and pay the tax each year by using IRS Form 990-T. This responsibility to file the return each year is on the IRA account owner and not the investment sponsor or the IRA custodian so IRA owners need to know for themselves whether the IRA is subject to UBIT or not. So for example, let’s say that a self-directed IRA invested into a Crowdfunding offering that was a real estate development with properties held immediately for sale and that the income was ordinary income. Let’s further assume that the self-directed IRA received a K-1 for profits to the IRA for the year of $10,000. Based on the UBIT tax table, the IRA would owe UBIT tax in the amount of $2,420. This amount is due from the IRA to the IRS and is reported and payable using form 990-T.
If you’ve determined that the Crowdfunding offering income is passive (e.g. rental, capital gain), then you may still be subject to UBIT if the LLC or LP offering company is using debt to leverage and acquire its properties.
Does UBIT apply, Step 2: Will the investment be leveraged with debt?
Second, UBIT will apply to profits returned to your IRA from a Crowdfunding real estate offering (and really any real estate owned by your IRA) if the offering company uses debt to leverage its acquisition of properties. For example, let’s say the offering company raises $1M in cash to buy a $4M multi-family property. There will be $1M of cash invested into the property and $3M of debt. The property will therefore be leveraged 75% with debt.
Whenever an IRA’s investment is leveraged with debt, the tax code requires the IRA owner to determine what profits are attributable to the IRAs cash and what profits are attributable to the debt. The profits attributable to the cash invested is still treated as tax deferred (traditional IRA) or tax free (roth IRA) and is not subject to UBIT. The profits and income attributable to the debt, however, is called unrelated debt financed income (“UDFI”) and is subject to UBIT. IRC § 514. So, in the multi-family property example above where the property is leveraged 75% with debt, the self-directed IRA will be subject to UBIT tax on 75% of the income.
In order to calculate UBIT tax based on debt, you must first determine the leverage ratio. Once we know the leverage ratio, we can then begin to calculate how UBIT will apply. The good news is that the IRA is also allowed to take expenses against the property using the same leverage ratio and is able to take depreciation expenses which help to offset UBIT. In many situations, even where a property is cash-flowing the IRA will not be subject to UBIT because the property expenses and depreciation will offset UBIT income.
Let’s continue through this example to illustrate how this works.
Property Purchase Price = $4M
Debt/Leverage = $3M
Leverage Ration = 75%
Income = $1.3M
Income at Leverage Ratio (75%) = $975,000
Operating Expenses= $1,000,000
Operating Expenses at Leverage Ratio (75%) = $750,000
Net Leveraged Income = $225,000
Depreciation Expense ($4M / 27.5) = $145,500
Depreciation Expense at Leverage Ratio = $109,125
Net UDFI/UBIT Income = $115,875
SDIRA Investor Invested $20K and received 1.5% of Company Profit/Loss
SDIRA Investor 1.5% of Net UDFI/UBIT = $1,738.
Automatic IRS $1,000 deduction = $738 subject to UBIT/UDFI
UBIT Table Rate of 15% of $738 = $110 in UBIT is Due
As the example demonstrates, given the low-level of investment from the IRA it isn’t subject to much UBIT as the net UBIT income (after expenses and depreciation) keeps the tax rate on the low end of the tax table. That being said, 990-T tax returns must be filed by the IRA investor for the IRA and the IRA will be responsible for the tax due. Factors that will cause more UBIT are higher returns and income, larger investment amounts and ownership, and more leverage.
While self-directed IRA’s are subject to UDFI and UBIT on leveraged real estate investments, it is worth noting that self-directed 401(k) and other employer based plans are exempt from UDFI on leveraged real estate investments. IRC § 514(9). Unfortunately, self-directed IRAs do not receive this exemption.
So, in short, the quick list to determine whether UBIT will be due a self-directed IRA Crowdfunding real estate investment requires analysis of two issues. First, is the offering company’s income passive or is it ordinary. If it is ordinary then it is subject to UBIT. If it is passive, then it is only subject to UBIT if the company uses debt to leverage its investments. Once you can answer these questions you know whether UBIT will apply to your investment and whether your IRA will need to report and pay tax on its income.