Self-Direction Part 4 of 4



In our final blog on self-direction, we’re going to cover taxation your retirement account might be subject to. Many people are surprised to hear that if they self-direct the account in real estate that it will have to pay a tax. But it’s true! This is because the types of investments your account makes with a broker (stocks and bond, etc.) would not have to ever pay taxes on the income. But in real estate, you can make money in other ways that ARE taxed.

And if you are subject to this tax, then your retirement account must pay that tax in the year, or years, that it incurs the tax. And this means, the account itself, NOT YOU, pays the tax. And if don’t have enough funds in the account (because it’s invested elsewhere), you may have trouble paying it.

There are two types of taxes that you might face. For simplicity we’ll just call them the “business tax” and the “leverage tax.” Both are really part of what is called the unrelated business income tax (UBIT).

The business tax applies to any business your retirement account engages in. Remember that if you invest in stocks, your IRA is not “engaged” in the business; it just “owns” part of a business. If you want to do flips with your IRA and if it’s “regularly and consistently” engaged in doing flips, your IRA is now engaged in conducting business. The UBIT business tax applies! The only real advice we have from the IRA is the phrase “regular and consistent.” But they apply a broad definition to that. So if you want to use your IRA to wholesale deals, and it does so on a regular and consistent bases, then the money your IRA makes is taxable.

The UBIT business tax applies to both IRAs and 401Ks. It’s meant to level the playing field with other “for profit” businesses in those industries. Since your retirement account comes with tax benefits, it would have an unfair advantage in the marketplace, so the IRS taxes it. You can pretty much assume that any type of real estate investing strategy except rental properties, will be subject to this tax if it does it on a regular and consistent basis.

Rental property (rent income) is not subject to the business tax. However, it might be subject to the leverage tax. If your IRA buys a rental but needs help with paying the full purchase price, it can borrow the money (through a non-recourse lender or seller financing). But because it got outside help (even though not from you!), it still got a benefit and was able to purchase a property it otherwise couldn’t. And so, the IRS applies the UBIT tax to leveraged properties because of that outside benefit.

This “leverage” UBIT tax ONLY applies to properties purchased in IRAs, not 401Ks. That’s a big advantage of using the 401K option to self-direct.

The UBIT tax can be up to 37%. So, it can take a big chunk of your profits. The actual tax is more complicated to assess, so you must work with a good CPA when figuring out this tax. And with the “leverage” one, it’s only on the “proportion” of the property that is leveraged. So it may not be as bad as you think. And remember, it is just a tax. If you fail to pay or don’t pay the right amount, then you’ll just have to make that up in the event of an audit with late fees and penalties. You will not lose your IRA like with a prohibited transaction.

Again, let me end by saying that self-direction is an amazing investment tool. And you can really grow your retirement accounts and save a lot on taxes. But it is an advanced level strategy with a lot of nuances. But once you’re educated, you’ll be off on a great road to wealth.

Jeffrey S. Breglio, Esq.
Breglio Law Office and REI Mastery U
(801) 560-2180


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