Self-Directed IRA and Self Dealing

Tax, SDIRAs & Cost Segregation
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Self-Directed IRA and Self Dealing

Tanner Gish
Real Estate Investor · Whittier, CA · Member since 2014 · 58 posts · 3 votes

Hey Friends,

  There is probably some seminole BP thread that asnwers this already, but I haven't found it yet.

My account just put a damper on my plans to fund a Self Directed IRA this month with a 2015 max contribution, and a 2016 max contribution in early Jan, and to take those $13,000 to invest in a flip project I'm working on. I was told my plan has two shortcomings:

1) You cannot use proceeds from a self directed IRA to finance (purchase or rehab) any part of a deal you manage (even it the property is owned by an LLC, I still own the LLC)- this is "Self-dealing." True?

2) You cannot do this, and let's say, this $13k was all that was needed for rehab (let's say property was purchased with another loan) as equity ownership in the property, and after the flip, the profit share for that borrowed $13k was, say, $20 k (a 153% return), that this also not allowed- the rate of return cannot exceed what typical equity market return would be. I find this "counsel" I received pretty unbelievable, as I'm pretty sure Uncle Sam won't stop you from making this kind of return had you bought Netflix stock with your IRA years ago and made that kind of return.

  Humbly looking for your wisdom and advice. Thanks!

-Tanner

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Brian EastmanPro Member
Self Directed IRA & 401k Advisor · Wenatchee, WA · Member since 2014 · 2k+ posts · 2k+ votes
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@Tanner Gish

I guess my earlier post was not entirely clear.  I was rushing out the door to run a shift at the scouts tree lot.

There is no limitation on the rate of return that an IRA may receive. A self directed IRA is no different from any other IRA when it comes to tax rules. You just have a different type of vehicle that may invest differently.

There are, however, two taxes that get in the way of the scenario you mention - assuming perhaps that the IRA capital was an equity stake in someone else's flip property for example.

When a tax exempt entity such as as IRA, church, etc., engages in a trade or business activity on a regular or repeated basis, there is a trust tax known as UBIT that applies. This tax pre-dates IRA plans and was enacted by congress to prevent tax-exempt entities from driving tax-paying businesses out of business.

When an IRA uses leverage, there is another trust tax known as UDFI that applies to the profits derived from the non-IRA capital.

The two taxes do not double up, and UBIT tax precedence of UDFI, but on a highly leveraged flip one could have exposure to both.

If you want to go into tax-land, check out IRS publication 598.

With that background aside, you could successfully put IRA money to work in real estate. You just need to do the homework to understand the rules and strategize accordingly. It is tough to justify setting up a self directed IRA and potentially engaging tax counsel if you want to engage in the tax-implicated transactions indicated above for a $13K account. It is also difficult though certainly not impossible to put a smaller amount of capital such as that to work in real estate.

Investing in discounted notes, tax liens, or hard money lending are generally the types of avenues that work well with a newer account with less capital, as these strategies do not have tax implications and can be done with lesser funding.

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  • Tanner Gish
    OP
    Real Estate Investor · Whittier, CA · Member since 2014 · 58 posts · 3 votes
    10y

    *accountant

    0Reply
  • Brian EastmanPro Member
    Self Directed IRA & 401k Advisor · Wenatchee, WA · Member since 2014 · 2k+ posts · 2k+ votes
    10y

    @Tanner Gish

    Your CPA is 100% correct.

    There is no limit on what the IRA can receive from a legitimate arm's length investment, but it cannot be commingled with personal funds and certainly could not receive an outsized portion of the return from an investment of that nature even if it were not self-dealing.

    1Reply
  • Tanner Gish
    OP
    Real Estate Investor · Whittier, CA · Member since 2014 · 58 posts · 3 votes
    10y

    @Brian Eastman

    Brian,

     Thank you so much for this input- I really appreciate it!

    One question on #2 (about the IRA not being allowed to have an, I guess we'll say "Exuberant," or beyond market average return): if an investor purchased any stock in the early years of some major corporations just before their future surge in value (Netflix, Apple, Google, etc), there would be no legal ramifications for the equity appreciation in that non-self directed IRA, right? Is there an explanation for why there isn't such a limitation in this example, but there is in the self-directed IRA (assuming it's not in a self-dealing, but in a legitimate, deal, with higher returns)?

      Thanks Brian, or whoever else can weigh in!

    -Tanner

    0Reply
  • Brian EastmanPro Member
    Self Directed IRA & 401k Advisor · Wenatchee, WA · Member since 2014 · 2k+ posts · 2k+ votes
    10y

    @Tanner Gish

    I guess my earlier post was not entirely clear.  I was rushing out the door to run a shift at the scouts tree lot.

    There is no limitation on the rate of return that an IRA may receive. A self directed IRA is no different from any other IRA when it comes to tax rules. You just have a different type of vehicle that may invest differently.

    There are, however, two taxes that get in the way of the scenario you mention - assuming perhaps that the IRA capital was an equity stake in someone else's flip property for example.

    When a tax exempt entity such as as IRA, church, etc., engages in a trade or business activity on a regular or repeated basis, there is a trust tax known as UBIT that applies. This tax pre-dates IRA plans and was enacted by congress to prevent tax-exempt entities from driving tax-paying businesses out of business.

    When an IRA uses leverage, there is another trust tax known as UDFI that applies to the profits derived from the non-IRA capital.

    The two taxes do not double up, and UBIT tax precedence of UDFI, but on a highly leveraged flip one could have exposure to both.

    If you want to go into tax-land, check out IRS publication 598.

    With that background aside, you could successfully put IRA money to work in real estate. You just need to do the homework to understand the rules and strategize accordingly. It is tough to justify setting up a self directed IRA and potentially engaging tax counsel if you want to engage in the tax-implicated transactions indicated above for a $13K account. It is also difficult though certainly not impossible to put a smaller amount of capital such as that to work in real estate.

    Investing in discounted notes, tax liens, or hard money lending are generally the types of avenues that work well with a newer account with less capital, as these strategies do not have tax implications and can be done with lesser funding.

    3Reply
  • Greg Kimura
    Investor · Castaic, CA · Member since 2015 · 19 posts · 4 votes
    10y

    @Brian Eastman

    As a thought, would a Solo 401k have the same problems regarding UBIT tax or UDFI?  

    I know that a Solo 401k cannot co-mingle personal and retirement funds (can't be used for a personal or direct family benefit), so the OP #1 applies, just like a SIDRA.

    0Reply
  • Brian EastmanPro Member
    Self Directed IRA & 401k Advisor · Wenatchee, WA · Member since 2014 · 2k+ posts · 2k+ votes
    10y

    @Greg Kimura

    A Solo 401k is subject to UBIT when the plan engages in a trade or business on a regular or repeated basis.

    Solo 401k plans are, however, exempted from UDFI taxation on debt-financed real estate.

    0Reply
  • Greg Kimura
    Investor · Castaic, CA · Member since 2015 · 19 posts · 4 votes
    10y

    @Brian Eastman

    I just pulled this from the IRS site:

    The Internal Revenue Code contains a number of modifications, exclusions, and exceptions to unrelated business income. For example, dividends, interest, certain other investment income, royalties, certain rental income, certain income from research activities, and gains or losses from the disposition of property are excluded when computing unrelated business income.

    According to the above, the investment would be considered income from dividends, interest or certain other investment income, which would exclude it from UBIT?  The SIDRA would still have the UDFI problem, but a Solo 401k would be okay.

    He still can't do it because of #1, but he wasn't involved with the flip (ownership), then he could use a Solo 401k.

    I may be missing something, but I think I'm correct.

    0Reply
  • Brian EastmanPro Member
    Self Directed IRA & 401k Advisor · Wenatchee, WA · Member since 2014 · 2k+ posts · 2k+ votes
    10y

    @Greg Kimura

    Unfortunately you are mistaken in your reading.  The income generated from flipping houses is certainly not dividends.  When one is acquiring, perhaps rehabbing, and reselling property, this is a dealer activity* , not the type of passive investment income for which there are exceptions to UBIT as you note.

    * not to be confused with "dealer status", specific to real estate, which is an entirely different thing for after-tax investors 

    The plan is buying and selling, and the property is the inventory of the sales business.  This type of activity is subject to UBTI when carried on with any regularity.

    Rents from real property, dividends, royalties and interest, are passive forms of income not subject to UBIT. For this reason, many IRA and 401k investors not wanting to take on the complexities of UBIT choose to be hard money lenders with their plan and receive interest.

    We do have clients who flip houses (or cars, boats, airplanes, etc.) and accept UBIT as part of the cost of those types of opportunities. If your net ROI after UBIT is still better than other opportunities into which you can invest your IRA or 401k, then you are still coming out ahead. If you can flip a house with your plan, pay UBIT, and still see a 20%+ net return, for example, that is likely better than your IRA or 401k would see as a hard money lender or landlord.... and likely a whole lot better than most folks are seeing in the stock market.

    1Reply
  • Greg Kimura
    Investor · Castaic, CA · Member since 2015 · 19 posts · 4 votes
    10y

    @Brian Eastman

    Thanks for the clarification.

    I see how using certain terms such as dividends, interest of certain other investment income can be interpreted in a way which the IRS doesn't agree.  Since we're talking about the IRS (taxes), using their definitions is the only thing that matters.

    It's good to know that the UBIT rule applies to flipping houses (as a regular or repeated basis).  As you posted, one can do an accurate analysis of the profit based on UBIT.

    Thank you for sharing.

    Greg

    0Reply
  • Alin Toncz
    Contractor · Columbia, TN · Member since 2015 · 52 posts · 24 votes
    10y
    Wow, my brain is already fainting from complexity of trying to make an honest living & many govt regulations & its taxation code that scares many new investors into this business. Not trying to get political but the more I read about endless rules the more I (and many like me) wish for a simpler tax code of a "flat tax".
    0Reply
  • Mike HurneyPro Member
    Real Estate Investor · Boston, MA · Member since 2009 · 2k+ posts · 542 votes
    10y

    @Alin Toncz Tax Code is not that bad if you use it all the time.

    You may want to get someone good like @Brian Eastman or @Carl Fischer to handle any SD IRA investing.

    0Reply
  • Jo-Ann LapinPro Member
    Loan Officer · Tustin, CA · Member since 2015 · 3k+ posts · 713 votes
    10y

    Yes, 100% correct. You cannot double dip. All the best.

    [email protected]
    0Reply
  • Mark Nolan
    Professional · Carlsbad, CA · Member since 2012 · 12k+ posts · 1k+ votes
    10y

    @Tanner Gish

    If you are trying to use your retirement funds to finance a real-estate operating business the ROBS 401k is a possibility but specific rules apply. The following IRS link sheds some light on this.

    https://www.irs.gov/Retirement-Plans/Employee-Plan...

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