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Beware The UBTI Rule When Investing In Real Estate With Retirement Funds

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Since the creation of individual retirement accounts (“IRAs”) the Internal Revenue Service (“IRS”) has always permitted an IRA or other retirement account to purchase, hold, or flip real estate. In fact, it states it right on the IRS website. By using a Self-Directed IRA or 401(k) plan, one will gain the ability to buy real estate, such as raw land, residential or commercial property, flip homes, and much more without paying tax. One of the major advantages of flipping homes with a retirement account is that all gains are tax-deferred until a distribution is taken (Traditional IRA distributions are not required until the IRA owner turns 70 1/2). In the case of a Roth IRA, all gains are 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) which can be found in Internal Revenue Code Section 512.

The purpose of the UBTI rules is to treat tax-exempt entities, such as charities, IRAs, and 401(k) plans as a for-profit business when they invest in an active trade or business operated through a pass-through entity, such as an LLC or partnership (a C corporation would block the application of the UBTI tax rules) or use leverage (there is an exemption to the UBTI rules for 401(k) plans who use non-recourse leverage). The tax imposed by triggering the UBTI rules is quite steep and can go as high as 40 percent.

In general, most passive investments that a retirement account might invest in are exempt from the UBTI rules. Some examples of exempt types of income include: interest from loans, dividends, annuities, royalties, most rentals from real estate, and gains/losses from the sale of real estate.

However, for real estate investors looking to buy and sell multiple real estate properties in a year or use leverage, one must be conscious of the application of the UBTI tax rules. The key point when determining whether a retirement account real estate transaction or series of transactions rises to the level of a trade or business are based on the facts and circumstances. In Mauldin v. Comr. 195 F.2d 714 (10th Cir. 1952), the court explained that there is no fixed formula or rule of thumb for determining whether property sold by a taxpayer was held by him primarily for sale to customers in the ordinary course of his trade or business. Each case must rest upon its own facts. The court identified a number of helpful factors to point the way, among which are the purposes for which the property was acquired, whether for sale or investment; and, continuity and frequency of sales as opposed to isolated transactions. In addition, in Adam v. Comr. 60 T.C. 996 (1973), acq., 1974-1 C.B. 1., the Tax Court analyzed the following factors in determining whether the taxpayer was engaged in the operation of a trade or business:

  • The purpose for which the asset was acquired
  • The frequency, continuity, and size of the sales
  • The extent of improvements made to the property
  • The proximity of sale to purchase

Generally one or two real estate transactions in a year would not rise to the level of a trade or business and trigger the UBTI tax rules. The question then becomes what happens if your retirement account engages in three, four, or even ten 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. The burden falls on the retirement account holder to make the determination of whether the retirement account engaged in a trade or business and, if so, file the IRS Form 990-T. 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.

For more information about the UBTI rules, please contact us @ 800.472.0646.

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Posted in Self-Directed IRA