With a Solo 401(k)Plan, flipping homes or engaging in a real estate transaction is as simple as writing a check. As trustee of your Solo 401(k) Plan, also known as an Individual 401(k) or Self-Directed 401(k) Plan, you will have the authority to make real estate investment decisions on behalf of your 401(k) plan on your own without needing the consent of a custodian. One of the true advantages of a Solo 401(k) Plan is that when you want to purchase a home with your Solo 401(k) Plan, you can make the purchase, pay for the improvements, and even sell or flip the property on your own without involving the custodian. And the best part is that all gains generated from the house flipping transaction will flow back to the Solo 401(k) Plan tax-free!
When engaging in real estate transaction, such as a house flipping transaction, one must keep in mind the Unrelated Business Taxable Income Rules (also known as UBTI or UBIT).
The purpose of the UBTI rules is to treat tax-exempt entities, such as charities, IRAs, and 401(k)s as a for-profit business when they engage in active business activities or use leverage.
The UBTI rules generally applies to the taxable income of “any unrelated trade or business…regularly carried on” by an organization subject to the tax. The regulations separately treat three aspects of the quoted words—“trade or business,” “regularly carried on,” and “unrelated.”
- Trade or Business: In defining “unrelated trade or business,” the regulations start with the concept of “trade or business” as used by Internal Revenue Code Section 162, which allows deductions for expenses paid or incurred “in carrying on any trade or business.”
- Regularly Carried On: The UBTI rules generally only applies to income of an unrelated trade or business that is “regularly carried on” by an organization. Whether a trade or business is regularly carried on is determined in light of the underlying objective to reach activities competitive with taxable businesses. The requirement thus is met by activities that “manifest a frequency and continuity, and are pursued in a manner generally similar to comparable commercial activities of nonexempt organizations.” The determination of whether an activity is “regularly carried on” is generally a fact and circumstances test and is based on the particular facts of the transaction or set of transactions during the year.
- Unrelated: In the case of an IRA or Solo 401(k) Plan, any business activity will be treated as “unrelated” to its exempt purpose.
In the case of an IRA or Solo 401(k) plan, a transaction would not trigger the UBTI rules if the transaction is deemed not to be considered a trade or business that is regularly carried on. This typically involves passive types of activities that generate capital gains, interest, rental income, royalties, and dividends. The passive income exemptions to the UBTI rules are listed in Internal Revenue Code Section 512. However, if the tax-exempt organization engages in an active trade or business, such as a restaurant, store, or manufacturing business, the IRS will tax the income from the business since the activity is an active trade or business that is regularly carried on.
How does the UBTI Rules Apply to Flipping Homes?
The question is then asked, what level of real estate transaction must one cross before triggering the UBTI tax. Unfortunately, there is no clear test as to how many house flipping transactions or the number of real estate transactions one must engage in a given year in order to trigger the UBTI tax. In general, the IRS has a number of factors it will examine to determine whether one has engaged in a high enough volume or real estate transactions, such as home flipping, to trigger the UBTI tax. Firstly, the IRS will examine the frequency of the transactions – how many flipping transactions are done in a year. Secondly, the IRS will examine the intent of the person – was the person intending to engage in an active trade or business. Thirdly, the IRS will also look at the scope of other activities of the tax-exempt entity to determine whether the activity is part of a business activity or an investment.
The determination of whether an activity is an active trade or business and will, thus, trigger the UBTI tax, which is taxed at a rate of approximately 40% for 2018, depends on the facts and circumstances. Clearly one or two flipping transactions would not be considered an active trade or business and would, thus, not trigger the UBTI tax. The question then becomes what happens if you do 3, 4, or even 10 flipping transactions in a year – would that be considered an active trade or business and, hence, trigger the UBTI tax? Again, one must examine all the facts and circumstances surrounding the multiple house flipping transactions in order to determine whether the transactions in the aggregate would constitute an active trade or business. Therefore, it is important to work with a tax professional who can help one evaluate the transaction to determine whether the flipping transaction will trigger the UBTI tax.