“Humpty Dumpty sat on a wall,
Humpty Dumpty had a great fall.
All the king’s horses and all the king’s men
Couldn’t put Humpty together again “
Author unknown but probably a 18th century English tax lawyer?
Please allow me to share one of the worst stories I have ever heard in real estate. A Missouri seller convinces a California buyer to “use her retirement money” to buy several rental houses. The buyer failed to obtain outside advice, and simply withdrew the funds to purchase the properties.
Rumors, innuendo and speculation are very dangerous in this arena and as a result the buyer was subject to all of the applicable penalties associated with withdrawals from her 401k. If I remember correctly it was about a $40,000 tax bill.
The worst part about tax planning is it looks like humpty dumpty some times… all the king’s horses could not unwind the transaction.
The teaching point from this outrage of a result: ALWAYS consult tax and legal counsel before acting to self direct your retirement funds.
That caution aside, I am a huge proponent of self directing retirement funds. I believe that Wall Streets capabilities are largely in marketing. Their financial acumen in general…ehhhh. Don’t even get me started on their transparency. You’re as good as they are.
So, as you can imagine I think self-directed retirement funding is very wise. As you know I am a staunch proponent of the wealth creation effects of real estate, because when done right – they are in many ways superior to stock investing.
The key competitive advantages in my mind are:
- Less volatility
- Opportunity to force appreciation
- Easier to find an information advantage
So having said that its important to talk about one of the hidden boogie men…errr provision in the retirement realm. The opportunity to tax defer or in the case of using after tax dollars of the beautiful ROTH provisions tax-free growth is greatly affected by this concept.
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1. What the heck is UBIT?
Unrelated Business Income Tax as defined by the IRS:
“For most organizations, an activity is an unrelated business (and subject to unrelated business income tax) if it meets three requirements:
- It is a trade or business,
- It is regularly carried on, and
- It is not substantially related to furthering the exempt purpose of the organization.
There are, however, a number of modifications, exclusions, and exceptions to the general definition of unrelated business income.”
2. Fix and Flips are NOT a good fit for SDIRA’s because of UBIT
The problem with self-directed IRAs and the fix and flip strategy lies in the UBIT. Word on the street is 1 to 3 flips a year are “probably” okay but I urge caution. If you want to go full “J Scott” and flip 20 or more houses in one year the UBIT boogeyman suggest it MUST be outside of your retirement fund.
Perhaps fix rent then flip may work…but how far will that take us?
3. Hard money loans to flippers are great alternative?
From every source I have read making a hard money loan is the best way to play in the fix and flip space with regard to your retirement funds. The only true limit is how fast your money churns it seems.
I am not a professional tax adviser so take my word with a grain of salt but so far my research suggest that this strategy is available “all day long”.
In conclusion the opportunity to self direct and invest in real estate is way too sweet to pass up. However to avoid the tragedy that befallen humpty dumpty and her family…please engage professional advisers.
Photo Credit: thetalesend