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Real Estate Sale Leaseback and Retirement Funds

Real estate sale leaseback
3 Minute Read

Real estate sale leaseback transactions are gaining in popularity as we start the new year.  The COVID-19 pandemic accelerated the demand for sale leaseback transactions. A sale-and-leaseback is a financial real estate transaction where an owner of a real estate property sells it and then leases it back immediately from the new owner. A sale leaseback transaction allows the real estate owner-occupant of a property to sell it to an investor, while continuing to occupy the property. The seller then becomes a renter of the property while the purchaser becomes the landlord.

Key Points
  • A leaseback allows a property owner to sell to an investor but still occupy the property
  • Leasebacks are becoming more popular due to COVID-19
  • You must be aware of UBTI when using retirement funds to do a leaseback

In general, a sale leaseback transaction works as follows:

  1. The property’s current owner-occupier agrees to sell the asset to an investor for a fixed price, thereby becoming a tenant.
  2. The new owner agrees to lease the property back to the previous owner under a long-term leaseback agreement, thereby becoming a landlord.

Sale leaseback transactions are also growing in popularity among retirement investors.  There are two ways a retirement account investor can use their retirement funds to enter into a real estate sale lease back transaction.  The primary advantage of using a retirement account to enter in a real estate transaction is that, in general, all income and gains are tax-deferred, or tax-free in the case of a Roth.

Retirement Plan Options for Real Estate

Self-Directed IRA

A Self-Directed IRA offers one the ability to use his or her retirement funds to make alternative asset investments not offered by the traditional financial institutions. The Self-Directed IRA is seen a great investment diversification tool.  The IRS only describes the type of investments that are prohibited, which are very few.  A Self-Directed IRA can also establish an LLC as an investment vehicle for the plan. Anyone with earned income can open and fund a Self-Directed IRA.

Solo 401(k)

A Solo 401(k) plan is essentially a traditional 401(k) plan covering only one employee. In general, in order to be eligible to establish a Solo 401(k) plan, one must be self-employed or have a small business with no full-time employees (over 1000 hours during the year) other than a spouse or other owner(s).

Depending on your plan documents, like a Self-Directed IRA, a Solo 401(k) plan can be invested into alternative asset investments, such as real estate.  As trustee of the plan, you would have checkbook control over the investments.

The UBTI Tax

In most cases, income and gains from a Self-Directed IRA or Solo 401(k) plan are not subject to immediate tax. However, the Unrelated Business Taxable Income (“UBTI” or “UBIT”)  tax rules are triggered in three instances:

  • use of margin to buy stock
  • use of a nonrecourse loan to buy real estate (exemption for 401(k) plan)
  • investment in a business operated through a flow-through entity, such as an LLC or partnership

The tax imposed by triggering the UBTI rules is quite steep and can go as high as 37%.

Nonrecourse Loan & Real Estate Retirement Account Investment

When an IRA buys real estate that is leveraged with mortgage financing, it creates Unrelated Debt Financed Income (UDFI), a type of UBTI on which taxes must be paid.  But with a 401(k) plan, one can use leverage without being subject to the UDFI rules and the UBTI tax. This exemption under IRC 514(d)(9) provides significant tax advantages for using a 401(k) plan versus an IRA to purchase real estate.

In order to take advantage of the exemption under 514(c)(9), the loan must be a bona fide nonrecourse loan and the loan must be used to acquire real estate.  A nonrecourse loan is type of loan that is secured by collateral, which is usually property. If the borrower defaults, the issuer can seize the collateral but cannot seek out the borrower for any further compensation, even if the collateral does not cover the full value of the defaulted amount.  Whereas the use of a recourse loan (personally guaranteed loan) would violate the IRS prohibited transaction rules under IRC 4975(c).

Sale Lease Back Transaction & UDFI

It is clear that a Self-Directed IRA that engages in a sale lease back transaction and uses leverage would be subject to the application of the UDFI rules and potentially trigger the UBTI tax. However, for Solo 401(k) plans, will the exemption under IRC 514(c)(9) apply to sale lease back transactions.  Unfortunately, the answer is no.

IRC Section 514(c)(9)(B)(iii) is clear that any real estate transaction where the real estate acquired is leased back to the seller would not receive the benefit of the exemption for UBTI under IRC 514(c)(9).  Hence, in the case of a real estate sale lease back transaction, a Self-Directed IRA or a Solo 401(k) plan that uses a nonrecourse loan as part of the transaction would be subject to the UBTI tax on a portion of the net income or gains associated with the investment. However, a retirement plan that enters into a sale lease back transaction without the use of leverage would not trigger the application of the UBTI tax.

Overall, sale leaseback transactions can be highly profitable investments for retirement account investors.  However, it is important to be aware of the potential UBTI tax ramifications of using nonrecourse leverage as part of any sale leaseback transaction.

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