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.
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.
It’s finally here: My top ten list of frequently asked self-directed IRA questions! Whether you’re just getting started or you’ve been investing with a self-directed account for decades, make sure you know the answers to these ten questions. In most instances, I’ve linked to more comprehensive articles and videos on the subject. And of course, you can always crack open the best-selling book on the subject for even more information and detail: The Self-Directed IRA Handbook.
1. What is a self-directed IRA?
A self-directed IRA is an IRA (Roth, Traditional, SEP, Inherited IRA, SIMPLE) where the custodian of the account allows the IRA to invest into any investment allowed by law. These investments typically include: Real estate, promissory notes, precious metals, and private company stock. The typical reaction I hear from investors is, “Why haven’t I ever heard of self-directed IRAs before, and why can I only invest my current retirement plan into mutual funds or stocks?” The reason is that large financial institutions that administer most U.S. retirement accounts don’t find it administratively feasible to hold real estate or non-publicly traded assets in retirement plans.
2. Can I rollover or transfer my existing retirement account to a self-directed IRA?
Well, it depends. Here’s my chart that breaks down every possible scenario:
I have a 401(k) account with a former employer.
Yes, you can rollover to a self directed IRA. If it is a Traditional 401(k), it will be a self-directed IRA. If it is a Roth 401(k), it will be a self-directed Roth IRA.
I have a 403(b) account with a former employer.
Yes, you can roll-over to a Traditional self-directed IRA.
I have a Traditional IRA with a bank or brokerage.
Yes, you can transfer to a self-directed IRA.
I have a Roth IRA with a bank or brokerage.
Yes, you can transfer to a self-directed Roth IRA.
I inherited an IRA and keep the account with a brokerage or bank as an inherited IRA.
Yes, you can transfer to a self-directed inherited IRA.
I don’t have any retirement accounts but want to establish a new self-directed IRA.
Yes, you can establish a new Traditional or Roth self-directed IRA, and can make new contributions according to the contribution limits and rules found in IRS Publication 590.
I have a 401(k) or other company plan with a current employer.
No, in most instances your current employer’s plan will restrict you from rolling funds out of that plan. However, some plans do allow for an in-service withdrawal if you are at retirement age.
3. What can a self-directed IRA invest in?
Under current law, a retirement account is only restricted from investing in the following:
Collectibles such as: Art, stamps, coins, alcoholic beverages, or antiques (IRC 408(m));
And, any investment that constitutes a prohibited transaction pursuant to ERISA and/or IRC 4975 (e.g. purchase of any investment from a disqualified person such as a close family member to the retirement account owner).
The most popular self-directed retirement account investments include:
Rental real estate;
Secured loans to others for real estate (trust deed lending);
Private small business stock or LLC interest; and
Precious metals, such as gold or silver.
These investments are all allowed by law and can be great assets for investors with experience in these areas.
4. What restrictions are there on using a self-directed IRA?
When self-directing your retirement account, you must be aware of the prohibited transaction rules found in IRC 4975. These rules don’t restrict what your account can invest in, but rather, whom your IRA may transact with. 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). On the other hand, your retirement account could buy a rental property from your cousin, friend, sister, or a random third-party, as these parties are not disqualified persons under the rules.
Here’s a diagram outlining who is disqualified to your IRA:
Prohibited transactions should be avoided as the consequence is distribution of the entire account involved.
5. Can my self-directed IRA invest in my personal business, company, or deal?
No, it would violate the prohibited transaction rules if your IRA transacted with you personally (or with a company you own). In addition, your IRA cannot transact with or benefit anyone who is a disqualified person (e.g. IRA owner, spouse, children, parents, spouses of children, etc.)
6. What is a checkbook-control IRA or IRA/LLC?
Many self-directed retirement account owners, particularly those buying real estate, use an IRA/LLC (aka “checkbook-control IRA”) as the vehicle to hold their retirement account assets. An IRA/LLC is a special type of LLC, which consists of an IRA (or other retirement account) investing its cash into a newly created LLC. The IRA/LLC is managed by the IRA owner, and the IRA owner then directs the LLC investments and the LLC to take title to the assets, pay the expenses to the investment, and receive the income from the investment. There are many restrictions against the IRA owner being the manager (such as not receiving compensation or personal benefit) and many laws to consider, so please ensure you consult an attorney before establishing an IRA/LLC. For more details on the IRA/LLC structure, including cases and structuring options, please refer to my blog post, “New Case Answers Important Questions about IRA/LLCs.”
Here’s a simple diagram that outlines how the IRA/LLC (checkbook-control IRA) operates:
7. Can my IRA invest cash and can I get a loan to buy real estate with my IRA?
Your IRA can buy real estate using its own cash and a loan/mortgage to acquire the property. Whenever you leverage your IRA with debt, however, you must be aware of two things. First, the loan your IRA obtains must be a non-recourse loan. A non-recourse loan is made by the lender against the asset, and in the event of default the sole recourse of the lender is to foreclose and take back the asset. The lender cannot pursue the IRA or the IRA owner for any deficiency. Second, your IRA may be subject to a tax known as unrelated debt financed income tax (UDFI/UBIT).
8. Are there any tax traps? What about UBIT/UBTI?
The tax 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 exempt from UBIT includes the following.
Real Estate Rental Income (IRC 512(b)(3)) – Rent from real estate is investment income, and is exempt from UBIT.
Interest Income (IRC 512(b)(1)) – Interest and points made from the money lending 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.
So, make sure your IRA receives investment income as opposed to “business income”.
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 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. If your IRA has UBIT income, it must file it’s own tax return using IRS Form 990-T. The second instance occurs when the IRA invests into real estate activities whereby the IRA is deemed to be in the business of real estate as opposed to investing in real estate (e.g. real estate development, construction, significant short-term real estate flips).
9. What is unrelated debt financed income (UDFI)?
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, let’s say an IRA buys a rental property for $100,000, and that $40,000 came from the IRA and $60,000 came from 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, which is not retirement plan money, the IRS requires tax to be paid on 60% of the income. So, if there is $10K of net rental income on the property then $6K would be UDFI and would be subject to UBIT taxes.
10. Should I use a solo 401(k) instead of a self-directed IRA?
A solo 401(k) is a great self-directed account option, and can be used instead of an IRA for persons who are self-employed with no other employees (other than business owners and spouses). If you are not self-employed, then the solo K will not work in your situation.
A solo 401(k) is generally a better option for someone who is self-employed and still trying to maximize contributions, as the solo 401(k) has much higher contribution amounts ($54,000 annually versus $5,500 annually for an IRA). On the other hand, a self-directed IRA is a better option for someone who has already saved for retirement and who has enough funds in their retirement accounts which can be rolled over and invested via a self-directed IRA as the self-directed IRA is easier and cheaper to establish.
Another major consideration in deciding between a solo 401(k) and a self-directed IRA is whether there will be debt on real estate investments. If there is debt and the account owner is self-employed, they are much better off choosing a solo 401(k) over an IRA as solo 401(k)s are exempt from UDFI tax on leveraged real estate.
Here’s what the solo 401(k) look like and how the money flows:
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 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 6-month extension with the IRS by filing an extension request before the regular deadline.
If UBTI 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
$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.
Step One: 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.
Step Two: 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.
A recent Bankruptcy Court decision dealt with prohibited transaction claims against a self directed IRA owner who was using their IRA to flip real estate for profit. The claims were brought by a bankruptcy trustee who argued that the protected IRA was no longer an IRA because it engaged in a number of prohibited transactions. If the trustee is successful in disqualifying the retirement account because of a prohibited transaction, then the funds and assets held in such retirement account are no longer protected from creditors and may be used to pay debtors involved in the bankruptcy. While most prohibited transaction cases arise in Tax Court, I’m seeing more cases on prohibited transactions in Bankruptcy Court as trustees are becoming more aggressive and as self directed IRAs are becoming more popular.
The case in question is known as In re Cherwenka, Case 13-57592-MGD (Bankr. N. D. GA 2014). The case included two important prohibited transaction analysis that are helpful to IRA owners.
Court Rules No Prohibited Transaction When Managing IRA Investment Properties Without Compensation
The first significant ruling from the Court was that there was no prohibited transaction when the IRA owner completed the following tasks related to the IRA owned property.
Research and identified properties to buy
Appointed and approved work on the properties
Oversaw payments on the property for work from the self-directed IRA.
The Court reasoned that these actions do no constitute a “transaction” as defined in IRC § 4975 and as a result they cannot constitute a prohibited transaction. The Court further stated that, “…self-directed IRAs as qualified IRAs, necessarily implies that a disqualified person (the owner as fiduciary) will make investment decisions regarding the plan. The Court distinguished this case from In re Williams, 2011 WL 10653865 (Bankr E.D. Cal 2011) a similar case in which the self-directed IRA owner was managing properties owned by the IRA because in Williams the IRA was paying the self-directed IRA owner for the services. The court stated that it was the payment from the IRA to the IRA owner in Williams that caused the prohibited transaction and not the mere provision of managing the IRAs investment owned by the IRA.
Court Ruled That No Prohibited Transaction Occurred When IRA and Owner Invested Into Property Together
The second significant ruling from the Court was that there was no prohibited transaction when the IRA owner and the IRA co-invested into a property together. The property in question was owned 45% by the IRA and 55% by the IRA owner. The Court rejected the bankruptcy Trustee’s argument that such co-investment purchase resulted in a prohibited transaction and stated that the interests appeared to have been treated distinctly and that the HUD documents from the sale of the property show that the IRA and the IRA owner’s proceeds from the sale were treated separately and that they were apportioned properly. As a result, the Court concluded that no prohibited transaction occurred since there was no evidence of un-fair benefit between the IRA owner and his IRA. In its reasoning, the Court referenced DOL Opinion 2000-10A which addressed an IRA and the IRA owner co-investing into a partnership. In the Opinion the DOL states that, “a violation of section 4975 (c)(1)(D) or (E) will not occur merely because the fiduciary [IRA owner] drives some incidental benefit from the transaction involving IRA assets.” The Court referenced this opinion and stated that unless there is evidence of some un-fair benefit that no prohibited transaction occurred merely because of co-investment into the same property.
There are two key take-away’s for self-directed IRA investors from this case.
First, never take compensation or payment from the IRA for services rendered. It is clear that the Courts will find a prohibited transaction if you do and that you will no longer have an IRA.
Second, if you are buying property or others assets (e.g. LLC interests) between your IRA and yourself personally (or another disqualified person) those interests must be carefully calculated and treated such that there is no benefit going unfairly between the IRA and the disqualified person (e.g. IRA owner). In sum, get advice and plan carefully as there are many land-mines you could encounter when investing IRA funds with your own personal funds. Bottom line, it can be done but it can easily be done incorrectly.
Get My Free Self Directed Investor Toolkit and Weekly Newsletter!
You will receive my Free Self Directed Investor Toolkit and Subscribe to My Weekly Newsletter to receive the latest news and updates from our team.
Tom W. Anderson
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.
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.
CEO, Polycomp Trust Company
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.
President, Polycomp Trust Company
Mark J. Kohler
Mat is truly an expert on self directed IRAs, and his book is the one book that every self directed IRA investor should read.
Mark J. Kohler
CPA, Attorney, Author
I was referred to Matt for help in setting up an IRA owned LLC. Matt and his team did an incredible job completing the work in a few short days. The process was professional, efficient and cost effective. I continue to rely on Matt for guidance running the LLC and related real estate matters. Not only is Matt a good lawyer, he runs a great office. It is easy for me to recommend Matt and his team.
We have used Matt for many legal matters and he always comes through with shining colors. I highly recommend Matt for any legal or tax matter.
Real Estate Broker & Investor
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
I have retained Mathew Sorensen several times for multiple real estate deals and have been very pleased with his efforts and work product and will continue to use him in the future.
Real Estate Investor
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.
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.
I have had the opportunity to engage Mat's services on many occasions and have found him to be diligent and reliable. He has always been committed to delivering high-quality work and is very professional. He is well-liked and respected by his peers. He has my most sincere recommendation.
Mathew Sorensen is a great resource and I use him consistently for real estate law questions. He is a wealth of information and will always give you a great knowledge base. I have been using KKOS for a while now and am very impressed and happy with their services.
CPA, Real Estate Investor
Kenneth P. Child
[Mat] is completely devoted to his clients and continually strives to stay abreast of changes and updates in the law. Mat is an unbelievably hard worker and...I don't hesitate to recommend Mat's services to anyone as I know he will take care of them and give them simple, concise, and straightforward solutions to any legal issue they may be facing.
I am a partner in a law firm in Chicago and I have worked with Mat on my personal real estate and business ventures. Mat has given me practical and wise advice which has helped me make profitable decisions. I highly recommend Mat.
Attorney & Real Estate Investor
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.
"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."
"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.
"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."
"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."
Founder and Retired CEO, PENSCO 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.