Using a self directed IRA for rehab.

49 Replies

@Greg Wright

The mention of 10% early withdrawal penalty tells me you are looking for current income. That really does not work well in a self directed IRA, whether the investments are passive and entirely tax sheltered, or a trade or business activity subject to UBTI.

If your desire is to flip houses to derive income for yourself, the Rollover as Business Startup program is the correct way to accomplish this using existing retirement funds.

Yes that is correct, the business roll over sounds interesting but seems to be complicated with reporting rules and expensive start up $ 5,000 along with monthly fee.

@GregWright there are many other issues and complications with ROBS as well. My recommendation to anyone considering this is to go directly to an ERISA attorney who can set this up and continue to advise you so that you stay within IRS guidelines for this strategy. This is quite a bit more expensive than what you state above.

The other responders are also correct that when looking at using a self directed IRA as a strategy to build wealth for retirement, you don't look at it as a way to make current income as this would be prohibited.

Many of our clients, however, have considered holding real estate as a still profitable venture in their SD IRA even with UBIT. Many consider the returns in general to be so superior to traditional investments that even with UBIT factored in the growth is still there.

Jaime

@Will Barnard Is the loan also limited to 50% with $50K max and paid within 5 years? or longer if it's RE?  Is it limited to borrowing only once a year even if paid off in less than that?  Is it subject to UBIT and can it be mixed with personal funds?

Thank you in advance.

Adam  

Originally posted by @Adam A. :
Is the loan also limited to 50% with $50K max and paid within 5 years? or longer if it's RE?  Is it limited to borrowing only once a year even if paid off in less than that?  Is it subject to UBIT and can it be mixed with personal funds?  

Adam, the loan is limited to $50K or 50% of the balance, whichever is less. The maximum length of the loan is 5 years, if the loan is used to purchase primary residence then it can be extended to 15 years. 

If the plan allows, you can take more than one loan, however, any outstanding loan balance in the past 12 months will be factored into calculating maximum loan amount of the new loan.

The UBIT would apply if your plan is engaged in unrelated business activity. When you take participant loan - it is you, not the plan, who will then be making investments or doing anything else with the loan proceeds. So in this case UBIT will not apply. And yes, you can combine loan proceeds with your personal savings to make personal investment.

Participant loan feature of the Solo 401k is also great when you are considering a transaction that would otherwise be prohibited, but by taking the loan out you can do it in your name. 

Originally posted by @Adam A. :

@Will Barnard Is the loan also limited to 50% with $50K max and paid within 5 years? or longer if it's RE?  Is it limited to borrowing only once a year even if paid off in less than that?  Is it subject to UBIT and can it be mixed with personal funds?

Thank you in advance.

Adam  

 Correct, 50% of your vested interest up to a max of $50k for 401k loans. Every plan administrator is different regarding your other questions, most do allow multiple loans (so long as the total combined does not exceed the maximum) but some may not. As far as UBIT, that does not ever apply on loans from 401k accounts.

Terms are typically 5 years with a max of 15, but again, each admin is different and may have their own restrictions. Once you go to the solo 401k, you are the administrator so you get to set the terms so long as you do not violate the $50k max loan amount.

From my perspective as one who has clients that use their solo 401ks to buy and flip by using my team to bid buy renovate and sell, they will can get around 2 to 2.5 turns a year. My tram is the that is the dealer in real estate. Fr what I have heard from guys like Brian, Dmitriy, Jim Hitt from American IRA google his company. They manage over $300,000,000.00 in assets. I dont think two turns a year makes you a dealer in real esate. So my guess is that there would be no taxes due and you could continue to grow your money inside the solo 401k, tax free.

@Craig Brooksby

2 turns a year would meet the "regular and repeated" criteria outlined in IRS publication 598 under which UBTI applies.

"Dealer Status" is a different consideration and applies in the after-tax world.  Many people incorrectly want to equate dealer status as the threshold for judging exposure to UBTI under a retirement plan, and are at risk as a result.

So Brian are you saying this would trigger the tax?

As already stated several times on this thread, those looking to flip real estate using their retirement funds may want to consider a ROBS 401k/PSP for flipping, as it will not subject the retirement plan to UBIT. 

@Brian Eastman

I'm curious as to how this tax applies to all the checkbook IRAs I read about people doing. If they are lending money using their IRA LLC (checkbook IRA), it is passive but becomes an investment in an LLC that is generating business income (interest). I'm assuming the same rules apply to the checkbook LLC that would a standard self directed IRA and since it is interest income it isn't subject to UBIT but I couldn't find much specific information on that. Thanks.

@William Allen

Whether the investment is made directly from an IRA account held by a custodian or via a Checkbook IRA where such a custodial IRA is invested into a LLC so as to give the account holder more direct control has no impact on UBIT exposure.

UBIT applies when a tax exempt entity engages in a trade or business on a regular or repeated basis. Forming a LLC as an asset holding vehicle for an IRA is not, in and of itself, a business. Rather, it is the nature of the income producing activity itself that creates the distinction.

Flipping houses is considered a trade or business activity, not a passive investment. The real estate is being purchased and sold, and becomes in effect the inventory of a sales business. If an IRA investor participates in flips with their IRA on a regular or repeated basis, and has an equity stake in the profits of the deal, such profits are subject to UBIT.

If, however, an IRA investor loans money to a contractor or other investor, this is a lending transaction whereby the IRA is receiving passive interest income. There is no exposure to UBIT in this scenario.

Refer to IRS Publication 598 for more information on UBIT.

Originally posted by @Brian Eastman :

@William Allen

Whether the investment is made directly from an IRA account held by a custodian or via a Checkbook IRA where such a custodial IRA is invested into a LLC so as to give the account holder more direct control has no impact on UBIT exposure.

This was the exact quote I was looking for and answers the question perfectly.  Thank you!

So if I am understanding this right I can use the loan feature to flip with but I wouldn't be able to have the Ira/401k act as my personal mortgage banker to fund the flips.  Is this true?

I know my employer 401k has limits on the amount of the loan I can take are there loan limits on self directed plans?

@Donald Dienst

You are correct, you can't use your IRA/401k to fund your own deals (because you are considered to be a disqualified person).

As described above the limit on the participant loan is $50K or 50% of the account balance, whichever is less.

Originally posted by @Will Barnard :
The comments regarding "arms length transactions" is 100% correct and spot on. That means you can not self deal (invest IRA funds from your account into properties you own) and you can not invest those funds with any disqualified parties.

Is having an equity interest in a rehab property as an investor from an IRA prohibited, or is this acceptable?

@Greg Wright

The UBIT or UDFI applies in years that profits are paid out but the distribution taxes only apply when taken from the IRA-generally at retirement age.

Originally posted by @John R. :
Originally posted by @Will Barnard:
The comments regarding "arms length transactions" is 100% correct and spot on. That means you can not self deal (invest IRA funds from your account into properties you own) and you can not invest those funds with any disqualified parties.

Is having an equity interest in a rehab property as an investor from an IRA prohibited, or is this acceptable?

John, perfectly fine to use IRA funds to take a percentage ownership of the property (equity stake) that is intended to be flipped, however, flipping is an "active and competing business" and as such, your profits on said equity stake WILL be subject to UBIT taxes. Also, the invested funds, the return of that capital and all profits MUST go back to the IRA and not you personally.

Many are scared off by UBIT and avoid such transactions as most people hate paying Uncle Sam more money. One must keep in mind that although we don't like paying taxes, having a taxable event means you made more money so their is a silver lining. Keep in mind that if your return after having to pay the UBIT was higher than you could get with a rental unit, making a loan, or other non UBIT taxed investment inside the retirement plan, then having the UBIT tax could be a better result than those without it. You must ultimately weigh each investment side by side and see which provides the higher return while taking into account which has higher risk and requires more of your time.

If I were to use funds from my SD-IRA to invest in a rehabber's ongoing flips, say 2-4 a year, would the gains be subject to UBIT?

Example, rehabber finds a property, he does all the work, I'm only involved by funding the purchase and rehab from my SD-IRA. Once the property has been sold we split the profits 50/50 and my share goes back into my SD-IRA.

Versus, using my SD-IRA funds as a hard money loan.

@Neil Henderson

Your IRA would be subject to UBIT.

At issue is the nature of the income.  Passive income such as interest (hard money loan), rent from real property, dividends and royalties is not subject to UBIT.

When a tax-exempt entity receives trade or business income, such as a split of the profits on a business transaction like flipping a house, then that business income is subject to UBIT.

The intent of the law is to retain a level playing field for tax-paying businesses, by imposing a cost on tax-exempt entities when they compete with tax-paying businesses by conducting commercial activities.

@Neil Henderson  

If you simply funding the project by being a private lender - this income is passive.

However, in your description profits are split 50/50 which means that you take ownership in the project. If the project is active business then earnings from that may be subject to UBIT. Please be sure to consult with the experienced CPA who can guide you.

This is likely a bad deal for both you and your potential partner, @Neil Henderson . You should run some numbers.

A typical hard/private money loan will take about 25% or so of the profits. Partnering with the 50/50 terms you mentioned, which are typical, will take 50%. That is, even at the confiscatory terms most HML's charge (and we're guilty), it's almost always in the financial interest of a rehabber to borrow the money.

Similarly, if your retirement plan is going to partner, and earn 50% of the profit, it will have to pay UBIT at a rate that quickly approaches 39.6% as shown here. This could leave you with less than a straight hard money loan, to which UBIT would not apply.

Either way, lending will result in a greater profit for you and the rehabber. (Not to mention the issues that can arise from partnering)

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