One of the advantages of using retirement funds, such as a Solo 401(k) plan, to make investments is that, in most cases, all income and gains from the investment will flow back to the 401(k) plan tax-deferred or tax-free in the case of a Roth. This is because a 401(k) plan is exempt from tax pursuant to Internal Revenue Code (“IRC”) Section 401. In addition, IRC Section 512 exempts most forms of investment income generated by a 401(k) from taxation. 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, the IRS enacted a set of rules in the 1950s in order to prevent tax-exempt organizations, such as charities and later 401(k) and IRAs from engaging in an active trade or business not related to its exempt purpose and thus, having an unfair advantage because of their tax-exempt status. These rules have become known as the Unrelated Business Taxable Income rules, also known as UBTI or UBIT. If the UBTI rules are triggered, the income generated from that activities would generally be subject to close to a 40% tax for 2017. The type of income that generally could subject a retirement plan to UBIT is income generated from the following sources:
- Income from the operations of an active trade or business through a pass-through entity (i.e. LLC or partnership), such as a restaurant. Of note, a retirement account investing in an active trade or business using a C Corporation will not trigger the UBTI tax.
- Using margin on a stock purchase.
- Non-recourse leverage to purchase real estate (a non-recourse loan is a loan not personally guaranteed by the plan participant). Only a non-recourse loan can be used, as a recourse loan (a loan personally guaranteed by the plan participant) would trigger a prohibited transaction under IRC Section 4975.
When a retirement account 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. However, a 401(k) plan is exempt from UDFI pursuant to IRC Section 514(c)(9), which allows a few types of exempt organizations, such as schools, colleges, universities, and their “affiliated support organizations” as well as qualified pension, profit sharing, and stock bonus trusts, but not IRAs, to make debt-financed investments in real property without becoming taxable under IRC Section 514. Generally, debt financed investments by a qualified organization in acquiring or improving real property will be exempt from the UDFI tax rules if the transaction navigates through a long list of prohibitions set forth under IRC 514(c)(9). The price paid by the organization for the property or improvement must be fixed when the property is acquired or the improvement is completed, neither the amount nor the due date of any payment under the indebtedness can be contingent on the revenue, income, or profits from the property, the property may not be leased to the person who sold the property to the organization (sales and leaseback), and the qualified organization must hold the real estate directly. However, if the qualified organizations owns an interest in a partnership that holds an interest in real estate (i.e. real estate fund), the exemption to the UDFI rules can still be satisfied if the partnership satisfies the aforementioned restrictions and one additional rule, that can be satisfied in any of three ways:
- All partners are qualified organizations,
- All allocations of tax items from the partnership must be qualified allocations
- Allocations must satisfy the “fractions rule”
Using a 401(k) plan to purchase real estate using non-recourse leverage is generally more tax advantageous than using an IRA so long as one can satisfy the list of prohibitions under IRC 514(c)(9). Because of the complexity of the rules, one should consult with a tax attorney for more specific information on this subject.