Avoiding UBIT

How Avoiding UBIT is Accomplished with a Solo 401k

First, let’s talk about what UBIT is.  UBIT, or Unrelated Business Income Tax, is a tax that is applied when an “exempt” organization participates in a non-exempt activity and earns an income.  In other words, if you are in a tax-exempt organization (think charitable foundation, 501(c)3, or a retirement account), then you are limited to only engaging in activities that are related to your exempt purpose.  The IRS gives an example of a University (exempt organization) running a for-profit pizza place on its campus.  The tuition for the university is tax-exempt, but the income from the pizza joint is taxable.  And guess what?  They are taxed at the highest corporate rate of 35%! So, good idea to avoid UBIT altogether, correct?

So, how do you avoid UBIT when using your 401k?

Your goal is to keep your active business activities and your passive investment activities separate from each other.  This means not directly investing your retirement account funds directly into your active business.  Many real estate investors want to tap into their retirement funds and use that for their next deal.  Unfortunately, if they are active in the deal, then this could be considered an unrelated business income, and any profits are thereby taxable.  The IRS defines all of these terms if you need more clarification here.

Let’s say for example that you need seed funding for your business, and you don’t know anyone with money, but you have about $100k in your 401k.  You would roll that money over to a Solo 401k, and then borrow up to $50,000 (or $100,000 between you and your spouse) in the form of a “participant loan” from your pre-existing retirement funds. Remember, you can borrow up to 50% of the value of your 401k, but borrowing means repaying.  Luckily, you’re repaying yourself, so as long as it is done correctly, you don’t actually lose any money on your loan, and could stand to gain a lot in your business.

Now, when your business does well, you can contribute that money to your 401k, and pay yourself back as well.  Additionally, the IRS calls this a legitimate deal, so it is a true win-win!

Passive Deal Structure

Avoiding UBIT is not too terribly difficult if you follow these two simple rules:

• Active trade = Business Funds, not retirement money
• Passive Investment = Retirement Money Allowed

So, how do you avoid UBIT using passive deal structures?  Well, you keep your hands off of the business your investing in, much like you would if you were a passive stock investor in a public company.  The IRS calls out an active trade specifically in its list of “don’t dos,” so it would be wise to follow them.  The penalty for performing active service inside a deal with your retirement funds is a very aggressive taxation and fees, as well as any past due taxes as well.  I would avoid this at all costs.

So, here’s a good example of what not to do:

I roll my money into a Solo 401k, then use that money to start a business by “investing” into my new LLC.  My new LLC, we’ll call it D-A LLC for now, buys an ugly house to fix and flip for $50k straight from the 401k.  We end up making $50,000 in profit ($100k gross), and I have it in the contract that this money is split 50/50 between any investors (my 401k) and me.  So, I get $25,000 in my pocket, and my 401k gets $75,000 ($25k in profit and $50k to pay back initial investment).  Rinse and repeat!

This is a huge no-no because it is active participation in a passive investment structure.  This means that the $75k could potentially be taxed as UBIT for a total of $26,250, so you would actually end up with only $48,750 going back into your 401k- a net loss of $1,250 in retirement funds! Here is what I should have done instead:

I roll my money into a Solo 401k, then start an LLC separate from my 401k.  I use the money in my 401k to borrow $25,000 and then get another loan from a bank for $25,000 to invest in the same fixer home.  So, now my business has a 100% stake, and the bank has a promissory note from my company.  We flip the house successfully for $100k again, and pay off the bank and my loan from my 401k.  Let’s assume for argument’s sake that each loan cost us $2,500 in interest and fees, so we pay back $55,000, leaving $45,000 in profit for us.  We can then invest 25% of that into our 401k on top of the $17,500 limit if we so desire, for a total of $28,750 from one deal!

Hopefully this helps clear up any misconceptions about what you can and can’t do with your retirement investment funds in a self directed account!