Self-Directed IRA to purchase Short Term Rental with Arbitrage

OP

Investor · Czar WV · Member since 2021 · 12 posts · 4 votes

3y

Quote from @John Underwood:

UBIT is generally mandated when you borrow money for a self directed IRA asset. Solo 401k's are exempt from UBIT, if you can qualify (google this) it is a much better retirement vehicle.

I own 5 properties (LTR's in myself directed IRA and one so far in my Solo 401k. My IRA is buying another property for 50k next week. Both are ROTH's so I will never pay tax on the gains or incoming rents.

You sound like you already know the rules, but you can't ever use the property for you or your parents or kids as long as it is held in your IRA. You also never do any sweat equity work on the property.

One day when you retire, and your IRA does a distribution of the property from the IRA you can then use it as you wish.

Thanks John. I would be paying cash so that element of UBIT wouldn't concern me. I once owned a riverfront cabin in an IRALLC and followed all of the rules but I did long-term rental with it. I live in a different riverfront cabin so it was never tempting to use it. And as a long term the UBIT question never came up.

Now with this cabin I want to partake of the STR cashflow without getting caught up in UBIT or a prohibited transaction. I think even if I took on a partner with a 50/50 split I would be subject to UBIT on my IRA's cut of the profit. It seems like a long-term lease to an experienced host that roughly split the profit between me as landlord and them as operator would effectively work like a partnership without the downside.

OP

Investor · Czar WV · Member since 2021 · 12 posts · 4 votes

3y

Quote from @Collin Hays:

I bought a cabin once in a SDIRA. HUGE mistake. This scenario is fraught with IRS minefields. You're a one-eyed gopher in a cactus patch. Just don't do it.

Thanks Collin. Was the Cabin used as an STR? Was it just the complexity that you disliked or did you actually get tripped up?

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Collin HaysBusiness Member

Property Manager · Gatlinburg, TN · Member since 2020 · 3k+ posts · 4k+ votes

3y

Quote from @Robert Karnes:

Quote from @Collin Hays:

I bought a cabin once in a SDIRA. HUGE mistake. This scenario is fraught with IRS minefields. You're a one-eyed gopher in a cactus patch. Just don't do it.

Thanks Collin. Was the Cabin used as an STR? Was it just the complexity that you disliked or did you actually get tripped up?

There are a multitude of problems that you will encounter that render the whole exercise far more trouble than it is worth. Lots of "trip wires" in the tax code that end up being unavoidable, etc. It's just not worth it.

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Leslie Anne Morris

Real Estate Agent · Smoky Mountains, TN · Member since 2022 · 1k+ posts · 984 votes

3y

Pull up some of Tom Wheelwrights (CPA & advisor to Robert Kiyosaki) info regarding SDIRAs

Todd Goedeke

Contractor · Sheboygan, WI · Member since 2016 · 917 posts · 266 votes

3y

@Robert Karnes You can avoid UBIT by being a passive investor . Are you self employed? Consider having a property management company with you as owner to allow you to start a Solo401k. Once opened transfer IRA money( not Roth IRA) to Solo401k. Simplify your agreement with a property manager by leasing the new property to them.Check with your tax atty or CPA, you can t share in profits from a business without triggering UBIT. Structure lease terms so you receive in guaranteed income at least a 20% plus cash on cash return with 20% down payment. The advantage of Solo401k is that you can have debt, leverage. Include terms in lease where property manager pays for all furnishings, RE taxes, insurance, and interior maintenance.

Consider contacting IRA Financial Group or one of the contributors on this group regarding set up of your Solo401k. It's always helpful if Solo401k provider has a tax atty on staff to give you assistance with your STVR RE questions.

Chris SeveneyBusiness Member

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Investor · VA · Member since 2015 · 21k+ posts · 19k+ votes

3y

@Robert Karnes

Speak to your advisor as I would not think this would fly. You renting a property and not owning it to then rent it out would seem to look like an operating business where you are leasing something to generate revenue from it

Your sole purpose also for this is to not have to pay UDFI / UBIT.

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OP

Investor · Czar WV · Member since 2021 · 12 posts · 4 votes

3y

Quote from @Todd Goedeke:

@Robert Karnes You can avoid UBIT by being a passive investor . Are you self employed? Consider having a property management company with you as owner to allow you to start a Solo401k. Once opened transfer IRA money( not Roth IRA) to Solo401k. Simplify your agreement with a property manager by leasing the new property to them.Check with your tax atty or CPA, you can t share in profits from a business without triggering UBIT. Structure lease terms so you receive in guaranteed income at least a 20% plus cash on cash return with 20% down payment. The advantage of Solo401k is that you can have debt, leverage. Include terms in lease where property manager pays for all furnishings, RE taxes, insurance, and interior maintenance.

Consider contacting IRA Financial Group or one of the contributors on this group regarding set up of your Solo401k. It's always helpful if Solo401k provider has a tax atty on staff to give you assistance with your STVR RE questions.

You are nailing what I am looking for. Although I do already have the Roth IRA. Essentially setting up an arbitrage so a property manager can run an STR our of my "long-term" rental.

It would seem, if structured correctly, I can get at least a share of the larger returns from a STR while avoiding the UBIT and involuntary distribution concerns.

I may look into rolling over in a Solo 401k. Question in your suggestion, why not a Roth solo401k?

Thank you

OP

Investor · Czar WV · Member since 2021 · 12 posts · 4 votes

3y

Quote from @Chris Seveney:

@Robert Karnes

Speak to your advisor as I would not think this would fly. You renting a property and not owning it to then rent it out would seem to look like an operating business where you are leasing something to generate revenue from it

Your sole purpose also for this is to not have to pay UDFI / UBIT.

I may not have been clear. My SDIRA LLC would own the property. It would sign a long-term lease with an 3rd party, independent, experienced STR host/Property manager. They would have the STR business.

My SDIRA LLC would simply be a landlord that allowed the property to be sublet. I tossed in the percentage of business as many commercial leases have a gross sales component but if that were to trigger UBIT I would explore something different for that element.

The purpose is dual, avoid UBIT but also avoid an involuntary distribution. I think one or both would be triggered if I were the one operating the STR.

Thanks

Brian EastmanPro Member

Self Directed IRA & 401k Advisor · Wenatchee, WA · Member since 2014 · 2k+ posts · 2k+ votes

3y

Your plan is generally solid. The IRA can long-term lease the property to someone who will then be a short-term operator.

Unless you plan to acquire the property using mortgage financing, an IRA and Solo 401(k) will be largely similar. If you plan to use a non-recourse mortgage for the property, then looking for a legitimate fit for a Solo 401(k) could be worth your while to avoid tax on Unrelated Debt Financed Income (UDFI). Beware internet promoted schemes like being your own property manager. That is "technically" feasible but not always net-beneficial. There are a lot of trade-offs, complexities, and expenses involved that can effectively cost more than the amount of tax being paid on UDFI by an IRA. Why spend $1000 to save $800, figuratively speaking?

A fixed rent from the operator would clearly be passive rental income not subject to tax on Unrelated Business Taxable Income (UBTI).

The percent of revenue approach would be more aggressive. It {could} if structured properly still be considered passive income, but it could also be viewed by the IRS as operating business income subject to UBTI. You would definitely want to engage a tax attorney to consult on that topic. These are the types of interpretive details where if you ask 4 tax professionals you will get at least 3 answers. So, you just kind of have to determine how aggressive you want to be and what is the worst case scenario if 3+ years in the future the IRS determines you had a failure to file on UBIT. In addition to the tax, you will tack on penalties and interest. It does not disqualify the IRA, but it would result in a big dent in your returns.

The better approach may be an agreement with the operator for a higher than market rent due to the intended use, or perhaps some kind of periodic maintenance surcharge to cover the additional wear and tear of short term rentals.

Michael BaumPro Member

Olympia, WA · Member since 2016 · 8k+ posts · 7k+ votes

3y

So @Robert Karnes, I will say that with the euphemistically named Inflation Reduction Act maybe going into effect, that brings 87,000 new IRS agents into the mix. You will paint a HUGE target on yourself that says AUDIT ME. Over and over.

They will see us (investors) as people who are "rich" and are probably holding back.

Get a CPA who knows this stuff in and out who can help set it up and defend when the IRS comes calling. And I truly believe they will. They might look at this as a tax dodge even if it is legal.

OP

Investor · Czar WV · Member since 2021 · 12 posts · 4 votes

3y

Quote from @Brian Eastman:

Your plan is generally solid. The IRA can long-term lease the property to someone who will then be a short-term operator.

Unless you plan to acquire the property using mortgage financing, an IRA and Solo 401(k) will be largely similar. If you plan to use a non-recourse mortgage for the property, then looking for a legitimate fit for a Solo 401(k) could be worth your while to avoid tax on Unrelated Debt Financed Income (UDFI). Beware internet promoted schemes like being your own property manager. That is "technically" feasible but not always net-beneficial. There are a lot of trade-offs, complexities, and expenses involved that can effectively cost more than the amount of tax being paid on UDFI by an IRA. Why spend $1000 to save $800, figuratively speaking?

A fixed rent from the operator would clearly be passive rental income not subject to tax on Unrelated Business Taxable Income (UBTI).

The percent of revenue approach would be more aggressive. It {could} if structured properly still be considered passive income, but it could also be viewed by the IRS as operating business income subject to UBTI. You would definitely want to engage a tax attorney to consult on that topic. These are the types of interpretive details where if you ask 4 tax professionals you will get at least 3 answers. So, you just kind of have to determine how aggressive you want to be and what is the worst case scenario if 3+ years in the future the IRS determines you had a failure to file on UBIT. In addition to the tax, you will tack on penalties and interest. It does not disqualify the IRA, but it would result in a big dent in your returns.

The better approach may be an agreement with the operator for a higher than market rent due to the intended use, or perhaps some kind of periodic maintenance surcharge to cover the additional wear and tear of short term rentals.

Currently the intent is to pay cash from the SDIRA. You and Todd both talk about a Solo 401k in the context that it could use non-recourse financing without invoking UBIT. Is that the case? Also true with a Roth 401k?

Obviously pulling cash out to repeat makes a certain kind sense for scaling.

Thanks.

Brian EastmanPro Member

Self Directed IRA & 401k Advisor · Wenatchee, WA · Member since 2014 · 2k+ posts · 2k+ votes

3y

Both an IRA and Solo 401(k) can use debt financing such as a mortgage. The difference is that an IRA is subject to tax on the portion of income the IRA receives from the non-IRA money in the deal and a 401(k) has an exemption from that tax when the debt-financing is used for the acquisition of real property.

The UBIT cost of UDFI does not normally add up to that much in an IRA, and the net effect is a small reduction in the boost of returns that leverage creates, so it is still a net positive strategy. Of course, if you have the option for a Solo 401(k) and can eliminate both the tax and the headache of a separate tax return for your retirement plan, that is a win.

The exemption from tax on UDFI in a 401(k) applies whether the funds in the 401(k) are tax-deferred or Roth.

Be advised, UDFI (debt-financed income) is exempted, but UBTI (business income) is not. Those are two different forms of income that generate an obligation to pay UBIT.

OP

Investor · Czar WV · Member since 2021 · 12 posts · 4 votes

3y

Quote from @Brian Eastman:

Both an IRA and Solo 401(k) can use debt financing such as a mortgage. The difference is that an IRA is subject to tax on the portion of income the IRA receives from the non-IRA money in the deal and a 401(k) has an exemption from that tax when the debt-financing is used for the acquisition of real property.

The UBIT cost of UDFI does not normally add up to that much in an IRA, and the net effect is a small reduction in the boost of returns that leverage creates, so it is still a net positive strategy. Of course, if you have the option for a Solo 401(k) and can eliminate both the tax and the headache of a separate tax return for your retirement plan, that is a win.

The exemption from tax on UDFI in a 401(k) applies whether the funds in the 401(k) are tax-deferred or Roth.

Be advised, UDFI (debt-financed income) is exempted, but UBTI (business income) is not. Those are two different forms of income that generate an obligation to pay UBIT.

Thanks for the advice. I have all different kinds of IRA but solo 401k looks likely next.

Todd Goedeke

Contractor · Sheboygan, WI · Member since 2016 · 917 posts · 266 votes

3y

@Brian Eastman a NNN lease with a property manager takes into consideration wear and tear on property and furnishings. Property manager pays for all interior maintenance and furnishings with such a lease.

Robert , remember you can transfer all IRAs except ROTH IRAs into a Solo 401k,Thus avoiding UDFI tax on investment leveraging.