Question about tax free earnings with SDIRAs

31 Replies

I've been learning about SDIRAs and from what I understand when you use the money in your real estate business, the money you earn will be tax free. So as Amanda Han put it in podcast 49, if a wholesaler puts a $1,000 earnest money deposit down and then makes $10K from the deal, those earnings are tax free.

Does this also apply when you fix and flip a property? So if you buy a property for $50K and end up with $30K in profit, those earnings are not taxed?

It doesn't seem like that could be the case since people are doing 1031 exchanges but I'm just trying to figure out the best avenue to save on taxes for fix and flip deals.

Am I understanding this correctly?

Hi Christine,

I'll start off with the disclaimer that I am not tax professional and don't play one on HULU...however, I have a self-directed IRA and have done several different RE investments with it.

First, as you probably already know there are two types of SD IRAs:

1. SD IRA. Pre-Tax deposits into this account are Tax-Deferred. Once you reach a certain age...59 1/2 I believe, you can begin withdrawing money from this account without penalty, while paying taxes on the money at that time based on your tax bracket at that time. In your examples, any profits would continue to grow this account without tax consequences....until you begin withdrawing the money.

2. SD Roth IRA - After-Tax deposits into this account grow tax-free. The idea is that you've already paid the taxes on the seed money, you shouldn't pay it again on the growth. This is a great choice if you A) expect to be in a high tax bracket in retirement (great problem to have) or B) expect huge growth/returns on your investments (another great scenario). Basically, it's the optimists IRA. :-)

An SD IRA can be converted to a Roth. The downside is that a big chunk goes to Uncle Sam and Aunt Samantha now. Some things to consider before converting:

1. What will the expected investment amount be per transaction?...meaning, if you are going to be fixing flipping 500K homes, you'll need at least that amount and some reserves in your account. So if you have 600K now, you may want to wait before converting to a Roth, as you may end up with insufficient funds to do a transaction.

2. If the amount is not an issue, you may want to consider having a smaller Roth account for the $1K to $10K example that you gave above.

There are many more things to consider, but these are some of the basics. Hopefully, it helped. Many of the SD IRA administrators, like Pensco have free trainings that cover more details. And by all means make sure that your accountant chimes in and gives you their blessing before making a decision.

Last thing is that it sounds like your main goal is to avoid paying high taxes on Flips....join the Club! :-) Flipping can be flipping expensive when it comes to taxes. Make sure to keep good records so that you are writing off all of the allowable business related expenses. Even meals and entertainment with business partners and clients are potentially a tax write-off if you discuss business...see disclaimer above. Some investors do flips to build the war chest then use some of that money to buy and hold for income that is not so flipping expensive.

Do a web search for Sandy Botkin. He is a CPA, tax lawyer and ex-trainer to the IRS lawyers. I got a lot out of his training program. It gives amazing ideas on how to legally maximize business expenses while easily documenting them to audit-proof your return.

Good luck! Happy investing!

Peter

Hi Christine, on a fix and flip, you're spot on, that profit is not taxed until you distribute the funds. It's always a good idea to call around to some custodians, and like @Peter K. said, take advantage of the free training they have to offer.

I'm sorry @Gil Hartman and @Christine Oliphant , but income from fix and flips or wholesaling inside an IRA absolutely is taxed. Its subject to a tax called "unrelated business income tax" or UBIT. This is a tax put in place on tax free vehicles, one of which is IRAs. Any time you engage in an active business, like fix and flipping or wholesaling inside an IRA this tax comes into play. UBIT is a very nasty tax. The first $1,000 of income is not taxed. It then ratchets up over the next $10,000 and above that is 35%. Yep, 35% over a total income of $11,000.

If you make loans to a rehabber from your IRA then that income is not subject to UBIT.

There is a specific exemption for income from rental properties owned inside an IRA. But if you have debt financing, the exemption goes away and you're back to paying the tax on the debt financed portion.

Jon Holdman, Flying Phoenix LLC

@Jon Holdman At a certain number of flips, you would be subject to UBIT, correct. However, not every flip is subject to UBIT.

@Jon Holdman

I was not aware of UBIT on flips inside an IRA. What about flips inside a Solo 401K?

@Christine Oliphant @Jon Holdman @Randy King Let me explain a bit more. A dealer is someone who holds property for sale rather than for investment. At a certain number of flips within an IRA, you would reach your state's requirement for "dealer status", generally about 5-10 flips within a year.

Beyond that, the IRS has certain things they consider when determining if the real estate investor gets dealer or investment status, such as the reason the property was acquired, time period held, efforts of the taxpayer to sell the property, etc. So they look at intent when determining dealer status as well.

@Randy King A solo 401K maybe be subject to UBIT in the event it reaches the above mentioned dealer status. Solo 401Ks are exempt from UBIT in the case the real estate is leveraged.

Sorry, don't buy it. Intent matters, not the number of flips. If you buy a property with the intention of selling it and then do its an active business. In your own name, that makes it subject to SET and ordinary income tax. If you do it in an IRA, its subject to UBIT. There is no 5-10 property limit. Nor is every property classified the same. You could have some properties that you plan to hold and then end up selling some time later. Those would not be subject to UBIT. At the same time you can have other properties you buy to immediately resell or to fix and resell. Those are subject to UBIT.

Jon Holdman, Flying Phoenix LLC

@Jon Holdman Intent absolutely matters, I'm not disputing that. But you wouldn't be subject until you reach dealer status, and each state has a different definition/limit.

I'm saying this speaking from experience. We have clients who flips properties who are not subject to UBIT because they don't classify as an operating business. UBIT only kicks in when it's deemed you are an operating company, and if, by clearly "set and ordinary laws", you are not an operating company, you are not subject to UBIT.

@Gil Hartman this is a federal matter and state law does not come into play.

Everything works until you get caught. Your client won't survive an audit. I have discussed this exact topic with an attorney who specializes in SDIRAs. You are mis-advising your clients if you are telling them they can flip houses without paying UBIT.

Jon Holdman, Flying Phoenix LLC

Originally posted by @Jon Holdman :
Sorry, don't buy it. Intent matters, not the number of flips. If you buy a property with the intention of selling it and then do its an active business. In your own name, that makes it subject to SET and ordinary income tax. If you do it in an IRA, its subject to UBIT. There is no 5-10 property limit. Nor is every property classified the same. You could have some properties that you plan to hold and then end up selling some time later. Those would not be subject to UBIT. At the same time you can have other properties you buy to immediately resell or to fix and resell. Those are subject to UBIT.

My understanding is the same. But what's an active business? Say I buy notes with IRA funds. Some of which pay over the long term and some of which are non-performing and which I foreclose on asap and get a payout. What makes an activity an allowed investment as opposed to a business?

@Jon Holdman Thanks for the input.

Absolutely, state law comes into play. State law is what would determine your status as a dealer. As a SD IRA & Solo K custodian, we have spoken directly to many CPAs & attorneys regarding the matter. If the attorney you've spoken to has chosen to interpret the laws as flipping one property making you an operating company, that's his choice. However, if his opinion is that flipping a single property as an investment constitutes a good or a service, that's very limiting.

There are MANY factors that states and the IRS would look at in determining dealer status (making you an operating company, subject to UBIT). They look at how many properties you buy and sell per year, do you maintain a staff, how do you advertise, are you actively involved in the rehab of the property (which we know you can't contribute sweat equity in an IRA or Solo K), etc.

Kristine Marie Poe I think the question you pose gets down to the bones of the situation: What's an active business?

State law determines how you compute taxes for the IRS? Seriously?

@Steven Hamilton II I'd be curious about your take on all this.

IRS Real Estate Dealer definition

Real estate dealer. You are a real estate dealer if you are engaged in the business of selling real estate to customers with the purpose of making a profit from those sales. Rent you receive from real estate held for sale to customers is subject to SE tax. However, rent you receive from real estate held for speculation or investment is not subject to SE tax.

Notice what's missing? Any mention of state law or the number of deals involved. Further, notice that a person could have properties that are both dealer status properties and others that are not dealer status.

Yes, there are a bunch of test that might come into play to differentiate between close calls. But if you are actively wholesaling or fix and flipping in an IRA its not a close call. You are selling real estate with the purpose of making a profit on the sales.

UBIT is covered in detail in Publication 598. This document is difficult to cut and paste from. Section 3 (page 3) defines an Unrelated Trade or Business. There is an exemption for activites that are not "regularly conducted". The example they give is a hosptical auxiliary organization selling sandwiches for two weeks at a state fair. That's certainly NOT going to apply to someone who regularly engages in wholesaling or fix and flipping. Section 4 (page 4) defines some exclusions, including "Dividends, interest, annuities and other investment income" and Rents. The debt financing issue is discussed on page 15.

Jon Holdman, Flying Phoenix LLC

Originally posted by @Gil Hartman :
@Jon Holdman Thanks for the input.

Absolutely, state law comes into play. State law is what would determine your status as a dealer. As a SD IRA & Solo K custodian, we have spoken directly to many CPAs & attorneys regarding the matter. If the attorney you've spoken to has chosen to interpret the laws as flipping one property making you an operating company, that's his choice. However, if his opinion is that flipping a single property as an investment constitutes a good or a service, that's very limiting.

There are MANY factors that states and the IRS would look at in determining dealer status (making you an operating company, subject to UBIT). They look at how many properties you buy and sell per year, do you maintain a staff, how do you advertise, are you actively involved in the rehab of the property (which we know you can't contribute sweat equity in an IRA or Solo K), etc.

@K. Marie Poe I think the question you pose gets down to the bones of the situation: What's an active business?

Where are you getting the information that says state law determines dealership status for federal tax purposes?

Originally posted by @Jon Holdman :
State law determines how you compute taxes for the IRS? Seriously?
@Steven Hamilton II I'd be curious about your take on all this.
IRS Real Estate Dealer definition
Real estate dealer. You are a real estate dealer if you are engaged in the business of selling real estate to customers with the purpose of making a profit from those sales. Rent you receive from real estate held for sale to customers is subject to SE tax. However, rent you receive from real estate held for speculation or investment is not subject to SE tax.

Notice what's missing? Any mention of state law or the number of deals involved. Further, notice that a person could have properties that are both dealer status properties and others that are not dealer status.

Yes, there are a bunch of test that might come into play to differentiate between close calls. But if you are actively wholesaling or fix and flipping in an IRA its not a close call. You are selling real estate with the purpose of making a profit on the sales.

UBIT is covered in detail in Publication 598. This document is difficult to cut and paste from. Section 3 (page 3) defines an Unrelated Trade or Business. There is an exemption for activites that are not "regularly conducted". The example they give is a hosptical auxiliary organization selling sandwiches for two weeks at a state fair. That's certainly NOT going to apply to someone who regularly engages in wholesaling or fix and flipping. Section 4 (page 4) defines some exclusions, including "Dividends, interest, annuities and other investment income" and Rents. The debt financing issue is discussed on page 15.

@Randy King

@Christine Oliphant

Very wrong @Gil Hartman ,

Yes solo 401ks are subject to UBIT; however, there is an exemption from UDFI on Real Estate transactions.

State law is irrelevant for that purpose. The IRS will determine active vs passive. Some states do however have laws regarding this fact for their own purposes. It very much determines the activity and involvement. Facts and circumstances of each situation.

Yes, there is one court case showing that three flips were allowed before this individual was subject to UBIT; however, that is not the case for everyone. The facts in that ONE case were the individual had MANY other investments and happened to purchase several properties at a vary good margin. He then received offers to purchase.

You are an investment adviser, not an adviser of tax law. I pray you never advise one of my clients incorrectly.

Now, I need to get back to working on tax returns.

Medium hta logoSteven Hamilton II EA, Hamilton Tax and Accounting | [email protected] | (224) 381‑2660 | http://www.HamiltonTax.Net

Originally posted by @Gil Hartman :
@Jon Holdman Thanks for the input.

Absolutely, state law comes into play. State law is what would determine your status as a dealer. As a SD IRA & Solo K custodian, we have spoken directly to many CPAs & attorneys regarding the matter. If the attorney you've spoken to has chosen to interpret the laws as flipping one property making you an operating company, that's his choice. However, if his opinion is that flipping a single property as an investment constitutes a good or a service, that's very limiting.

There are MANY factors that states and the IRS would look at in determining dealer status (making you an operating company, subject to UBIT). They look at how many properties you buy and sell per year, do you maintain a staff, how do you advertise, are you actively involved in the rehab of the property (which we know you can't contribute sweat equity in an IRA or Solo K), etc.

Kristine Marie Poe I think the question you pose gets down to the bones of the situation: What's an active business?

Gil,

Some transactions are "Dealer" transactions and some are not. This very much depends upon the facts and circumstances of each properties acquisition and disposition.

Medium hta logoSteven Hamilton II EA, Hamilton Tax and Accounting | [email protected] | (224) 381‑2660 | http://www.HamiltonTax.Net

@Jon Klaus

thanks for asking, but this topic (taxation) is not my area of expertise and if/when asked, I would suggest speaking with qualified tax professional such as @Steven Hamilton II , he provided clear and concise answers, so thank you Steven!

Medium logo 19 1Dmitriy Fomichenko, Sense Financial | [email protected] | (949) 228‑9393 | https://www.sensefinancial.com/free-consultation/ | CA Agent # 01876563

@Jon Holdman @Steven Hamilton II I'm going to admit that I'm "very wrong" on the subject of state's determining dealer status. After reviewing everything and researching, it's clear that I was inflating the influence of a state's policy on what constitutes dealer status. The case could be made that if you aren't required to register as a dealer in your state, you could use that in your determination with the IRS, but that's neither here nor there.

I should also clarify, I am not an advisor, and I would always refer clients over to professionals, such as @Steven Hamilton II for advice.

That being said, I still don't think flipping 1 or 2 properties a year as an investment would automatically make the account holder subject to UBIT. As you've both stated, the IRS will look at many factors when determining this, such as level of activity, number of properties "flipped", etc. It's really never black and white.

Thanks a lot for the discussion everyone! I learned quite a bit!

Thank you for everyone's responses. This is obviously a complex topic and it sounds like if you don't have experience it is best to consult with your CPA to make sure things are done correctly.

And as @Peter K. said...flipping can be flipping expensive when it comes to taxes. Seems like that's the short version of it all! :)

Originally posted by @Gil Hartman :
@Jon Holdman @Steven Hamilton II I'm going to admit that I'm "very wrong" on the subject of state's determining dealer status. After reviewing everything and researching, it's clear that I was inflating the influence of a state's policy on what constitutes dealer status. The case could be made that if you aren't required to register as a dealer in your state, you could use that in your determination with the IRS, but that's neither here nor there.

I should also clarify, I am not an advisor, and I would always refer clients over to professionals, such as @Steven Hamilton II for advice.

That being said, I still don't think flipping 1 or 2 properties a year as an investment would automatically make the account holder subject to UBIT. As you've both stated, the IRS will look at many factors when determining this, such as level of activity, number of properties "flipped", etc. It's really never black and white.

Thanks a lot for the discussion everyone! I learned quite a bit!

One of the biggest items to determine if an activity is active is what is done in comparison. If it is the only activity in retirement accounts then it pushes toward active. If there are a great deal of other interests than it may not be considered flipping

Medium hta logoSteven Hamilton II EA, Hamilton Tax and Accounting | [email protected] | (224) 381‑2660 | http://www.HamiltonTax.Net

@Steven Hamilton II

I realize this is an old thread but this is the best thread I found concerning my questions about UBIT. It is my understanding that most investors using a SDIRA for real estate investing are using an LLC form the SDIRA to purchase properties, particularly for fix and flips. LLC's are subject to UBIT, but c corps are not. Is there a way to set up a c corp to purchase properties through the SDIRA in order to be exempt form the UBIT or is this not a possible structure for this purpose?

@Joshua Massari

Short answer is yes. An IRA or IRA LLC may hold shares of a C Corp. This is referred to as a blocker corp. Instead of paying trust taxes as high as 39.6%, the corporation will be taxed at more like 25%.

Find a very skilled attorney with experience in this area if you are considering such a strategy, and plan to keep them on board after the initial setup.

If you will be doing enough flipping, this can be worth doing.  Probably too much overhead for 1-2 deals per year.

Medium safeguard rgb stackedBrian Eastman, Safeguard Advisors | [email protected] | 855‑997‑2298 | http://www.ira123.com