I am looking at rolling my 401k into a self directed IRA with checkbook control in order to flip properties. I will be buying the properties using case from the SDIRA and reinvesting the profits back into it. So I went and got signed up with a SDIRA company and had an LLC formed to hold the money. I haven't rolled the funds over yet.
My question concerns UBIT. I heard that I may have to pay UBIT in the flip profits if I do more than a couple of flips per year. Is this correct? If so, then what will I be saving by using a SDIRA over a regular IRA and taking the money as I need it?
Also, I am a real estate licensee and was hoping to be able to do my own purchases and sales, but it sounds like I can't do that either at that would be self dealing.
Correct that if you act as the agent for property that will be purchased by the IRA, you cannot receive a commission.
The most conservative approach is not to act as an agent even for no commission as this could be challenged as providing services of value to the plan (similar to how you can’t provide sweat equity like fixing the toilet).”
With respect to flipping real estate inside an IRA, UBIT is always a concern regardless of the number of properties. For example, if from the beginning your intent is to consistently flip real estate inside the IRA, then there is a good argument that UBIT applies regardless of the number of properties.
IRAs were created to invest in passive investments (e.g., buy and hold real estate). As a result, if real estate is consistently flipped inside an IRA, the argument is that it is considered trade or business activity regularly carried on.
Brian Eastwood - a pro member on here can answer all your questions.
I use my funds in my SDIRA for buying notes. I had bought properties with my SDIRA but sold them and moved to notes. I found there were too many situations that could be flagged if I managed my SDIRA properties while managing my non-SDIRA properties. There are people who are doing this (buying property) but I don't know anyone who is using SDIRA funds to flip. Good Luck
you may have followed incorrect recommendation by setting up SD IRA with checkbook control. Much better option for you would be truly self-directed Solo 401k plan. As self-employed realtor you are eligible. Here are just a few of major advantages it has over IRA:
- Contribute 10 times more than an IRA (up to $61,000/yr)
- No UBIT on leveraged real estate
- Ability to take personal loan up to $50K (can't borrow a dollar from an IRA)
- Checkbook control without custodian and without an LLC
- Lower cost to setup and maitain
- Tax free investing utilizing Roth sub-account
It is also important to understand that UBIT applies to both IRAs and solo 401k plans; however, UDFI does not apply to solo 401k plans.
The Unrelated Business Income Tax (UBIT) is assessed when a tax-exempt entity, such as an IRA or a solo 401k plan, engages in a business activity that is not related to its general purpose. For example, if a self-directed solo 401k account is used to purchase a shoe store, the income generated from the business would be subject to UBIT. Reason being, selling shoes is no the general purpose of an solo 401k plan. This tax was created to keep tax-exempt entities on a level playing field with non-tax-exempt entities such as solo 401k plans and IRAs.
Similar to the UBIT, there is a another tax called the Unrelated Debt-Financed Income (UDFI) tax on IRA investment income derived from debt-financed property, proportionate to the debt on the property. HOWEVER, UDFI does not apply to solo 401k plans so this is why individuals prefer solo 401k plans over IRAs for investing in real estate whereby a none-recourse loan will be used.
Following are the similarities and differences between the solo 401k and the self-directed IRA.
The Self-Directed IRA and Solo 401k Similarities
- Both were created by congress for individuals to save for retirement;
- Both may be invested in alternative investments such as real estate, precious metals tax liens, promissory notes, private company shares, and stocks and mutual funds, to name a few;
- Both allow for Roth contributions;
- Both are subject to prohibited transaction rules;
- Both are subject to federal taxes at time of distribution;
- Both allow for checkbook control for placing alternative investments;
- Both may be invested in annuities;
- Both are protected from creditors;
- Both allow for nondeductible contributions;
- Both are prohibited from investing in assets listed under I.R.C. 408(m)
The Self-Directed IRA and Solo 401k Differences
- In order to open a solo 401k, self-employment, whether on a part-time or full-time basis, is required;
- To open a self-directed IRA, self-employment income is not required;
- In order to gain IRA checkbook control over the self-directed IRA funds, a limited liability company (IRA LLC) must be utilized;
- The solo 401k allows for checkbook control from the onset;
- The solo 401k allows for personal loan known as a solo 401k loan;
- It is prohibited to borrow from your IRA;
- The Solo 401k may be invested in life insurance;
- The self-directed IRA may not be invested in life insurance;
- The solo 401k allow for high contribution amounts (for 2017, the solo 401k contribution limit is $54,000, whereas the self-directed IRA contribution limit is $5,500);
- The solo 401k business owner can serve as trustee of the solo 401k;
- The self-directed IRA participant/owner may not serve as trustee or custodian of her IRA; instead, a trust company or bank institution is required;
- When distributions commence from the solo 401k a mandatory 20% of federal taxes must be withheld from each distribution and submitted electronically to the IRS by the 15th of the month following the date of each distribution;
- Rollovers and/or transfers from IRAs or qualified plans (e.g., former employer 401k) to a solo 401k are not reported on Form 5498, but rather on Form 5500-EZ, but only if the air market value of the solo 401k exceeds $250K as of the end of the plan year (generally 12/31);
- When funds are rolled over or transferred from an IRA or 401k to a self-directed IRA, the amount deposited into the self-directed IRA is reported on Form 5498 by the receiving self-directed IRA custodian by May of the year following the rollover/transfer.
- Rollovers (provided the 60 day rollover window is satisfied) from an IRA to a Solo 401k or self-directed IRA are reported on lines 15a and 15b of Form 1040;
- Pre-tax IRA contributions on reported on line 32 of Form 1040;
- Pre-tax solo 401k contributions are reported on line 28 of Form 1040;
- Roth solo 401k funds are subject to RMDs;
- A Roth 401k may be transferred to a Roth IRA (Note that from a planning perspective, it may be advantageous to transfer Roth Solo 401k funds to a Roth IRA before turning age 70 ½ in order to escape the Roth RMD requirement applicable to Roth 401k contributions including Roth Solo 401k contributions and earnings.);
- Roth IRA funds are not subject to requirement minimum distributions (RMDs);
- The fair market value (FMV) of assets held in a self-directed IRA is reported on form 5498;
- The fair market value of assets held in a solo 401k are reported on Form 5500-EZ;
- At termination, the solo 401k is required to file a final Form 5500-EZ and 1099-R; and
- At termination, the self-directed IRA is only required to file a form 1099-R.
You are correct regarding flipping, retirement accounts are designed to be invested passively and any income or gains generated from an active business will result in Unrelated Business Income Taxes. In my opinion it is not worth it to run an active business from your retirement accounts, there are plenty lucrative investment options to invest your retirement funds passively - that is what you should be doing. I personally invest my retirement funds in trust deeds (being a private lender) and note fund. Talk to @Dave Van Horn , I invested in one of his note funds and as a result getting "mailbox money" (check delivered to my mailbox monthly) at 12% interest.
Originally posted by @George Blower :
Correct that if you act as the agent for property that will be purchased by the IRA, you cannot receive a commission.
Acting as an agent for the IRA-owned property (regardless if you receive a compensation or not) is considered prohibited transaction. IRS rules are pretty clear, disqualified person can not provide any goods, services or facilities to the plan:
A Solo 401k sounds like it would be a better fit for you as long as you don't have any W2 employees. UBIT on flipping activity is a valid concern regardless of the retirement structure you choose. Unfortunately, it's not the case that there is an exact number of flips to stay under to avoid UBIT while going over that number will incur the tax. Whether there is UBIT from flipping depends on a number of factors (including the number of flips) and it the determination tends to be made on a case-by-case basis.
Unfortunately, it looks as if you have started on this project with less than full information and some incorrect expectations. That is easy enough to fix. What you have experienced is, I hate to say, not at all uncommon, especially in the internet age and this particular space of self-directed retirement plans. I would ask you to honestly share with the BiggerPockets community whether you rushed into this, or whether the particular plan provider you are working with was just selling services and not providing any meaningful information to assist you in your understanding of what works and what does not.
To summarize, there are a few key takeaways:
1) The Solo 401(k) plan format likely provides advantages to you as a self-employed realtor than the IRA based program does. The Solo 401(k) is a more direct route to checkbook control of the funds and therefore more cost-effective. It is also a more robust retirement plan with high contribution limits, Roth features and the availability of participant loans. And the 401(k) is more favorable for investing using debt-financing such as mortgages due to exemption from UDFI taxation on real property. You will have wasted a few dollars if you backtrack from the IRA LLC and move that direction, but it might be worth it over the long term. Not that the IRA LLC is a bad program, the Solo 401(k) is just better in some cases.
2) You should not act as the realtor for plan transactions. As a disqualified party, you may not benefit from the plan such as by receiving a commission, nor may you add value to the plan through the provision of goods or services. Executing contracts for the acquisition and disposal of plan assets is not such a service. Providing the services of a licensed realtor in that regard would be.
3) Flipping is not the highest and best use of a self-directed retirement plan. Tax sheltered retirement plans are exempted from taxation on gains from passive income sources such as interest, dividends, royalties, rent from real property, or the sale of an asset that has been held over time to produce passive income. When a tax-exempt entity engages in a trade or business on a regular or repeated basis and is therefore acting like and competing with tax-paying businesses, UBIT taxation is introduced to level the playing field and protect tax-paying businesses from unfair competition.
So... If the opportunities in your market are to flip properties, there are two alternative approaches that work within the IRA/401(k) space:
- Have the IRA/401(k) be the bank and lend money to an unrelated flipper. You can generally charge 1-3 points and 10-15% interest and that generates a solid return for your plan with a mortgage note as the underlying security. This interest is passive and not subject to UBIT.
- Execute what we have coined a "Hybrid-Flip". The advantage of flips is being able to buy at a discount, add value through rehab, and then capture that added value. If you buy-fix-sell in an IRA, that is a flip, which is a business, and subject to UBIT. If you acquire a property and rehab it, but then operate that property as a rental for a period of at least a year... then when you sell that is not a flip, but rather the liquidation of what has been held as a passive income producing rental. UBIT therefore does not apply. So, with a little patience, you can dramatically improve the ROI of the transaction by eliminating UBIT and perhaps with the positive cash flow from the rental.
Knowledge is power. By working with a knowledgeable professional in the self-directed retirement plan space - instead of just a processor or document marketing company - you can certainly find ways to put your tax-sheltered retirement savings to work in ways that will maximize your opportunity for wealth building by investing in what you know.
Thank you all for the clarifications. We went to three SDIRA providers and explained our wishes. None of them mentioned the UBIT or unsuitability of the IRA for flipping. Our CPA advised against it after I brought up UBIT and asked how the new tax laws would affect it.
So I guess I'm back at square one. I have retired, will be 59-1/2 in 3 months, and want to get at my retirement funds as quickly as possible to purchase multiple flips. Not interested in lending the money, and taking a $50K loan out on the 401k isn't enough for a flip in this area. What's the best way to get at my money? If I take it all out at once, I risk putting myself into a high tax bracket, although the new tax laws may change the situation some.
My current situation: I have an LLC formed, a custodial account with the IRA provider, no bank account to place the funds in yet, and the lawyer is wanting to know how to write the organizational documents for the LLC.
How best to get at my money for flips while paying as little as possible in taxes?
Flipping in the IRA is just not a good option tax-wise. You may wish to consider a Rollover as Business Startup (ROBS program). This allows you to use existing retirement funds to capitalize your own active business. The business would be a taxable C-Corporation and pay corporate tax rates which are now a whole lot lower than the trust tax rates the IRA would pay.
If done under the ROBS 401k plan, you will need to follow the real estate operating company requirements.
1) The corporation that you invest your retirement funds in may invest in real estate that satisfies the following requirements:
a. At least 50 percent of the assets of the business, valued at cost, must be invested in real estate which is managed or developed and with respect to which such entity has the right to substantially participate directly in the management or development activities.
b. Such entity in the ordinary course of its business must be engaged directly in real estate management or development activities.
2) Expenses related to the real estate will be paid by the corporation.
3) The real estate will not be used for personal use.
4) There may be periods of time when the 50% test described in 1(a) above is not satisfied. This confirms that it would be acceptable as long as the 50% test is satisfied on the following dates: (i) the “initial valuation date” or the first date on which the corporation makes an investment that is not a short-term investment of funds pending long-term commitment; and (ii) at least one day during each annual valuation period. An “annual valuation period” is an annually recurring period of not more than 90 days that begins no later than the anniversary of an entity’s initial valuation date. For example, if the corporation’s first long-term investment is made on October 3, 2017, that date is its initial valuation date. The first annual valuation period can commence as late as October 3, 2018. An annual valuation period that commences on October 3, 2018 would end on December 31, 2018 and recur each October 3 through December 31 thereafter. Once an annual valuation period is established it may not be changed except for good cause.
If you decide to instead cash-out your retirement account, you will need to pay federal, and possibly state taxes depending on your state of residence. However you will not need to pay the 10% penalty as it does not apply once you reach age 59 1/2. Unfortunately, when you take a distribution from a retirement account the amount distributed is taxed at earned income tax rates which may bump you into a higher tax bracket. To learn more about the distribution rules, see the following.https://www.irs.gov/retirement-plans/retirement-plans-faqs-regarding-iras-distributions-withdrawals