Self-directed IRA and Solo 401(k) Plans are very popular with real estate investors. Such plans allow an investor to put their tax-sheltered retirement savings to work investing in what they know instead of being limited to financial products.
A lot of investors come to us wanting to use a self-directed IRA to flip houses. On the surface, this seems like a good idea, especially for someone with experience flipping. Flipping can be very profitable when done well.
Unfortunately, flipping inside of an IRA often becomes undesirable due to the potential for exposure to Unrelated Business Income Tax (UBIT). UBIT is a trust tax that applies when a tax-exempt entity like an IRA regularly engages in a trade or business and is therefore competing with taxpaying businesses. Flipping houses is considered a business activity and therefore has this tax exposure if pursued as a concerted strategy inside of an IRA.
The federal tax rate on UBIT can get to be as high as 37%. That can really put a dent in the ROI your IRA may receive from a flip transaction.
With the passage of the 2017 Tax Cuts and Jobs Act the federal corporate tax rate was lowered to 21%. This presents an opportunity to use IRA funds for flipping that can be much more profitable. If you plan and investment strategy involving multiple flip transactions, then you will want to explore the concept of a UBIT Blocker Corporation.
Background – Understanding UBIT
In the past, the main obstacle to flipping houses in an IRA was exposure to UBIT. A tax-exempt entity such as an IRA has exposure to Unrelated Business Income Tax when it engages in a trade or business activity on a regular or repeated basis. In real estate, this includes active real estate transactions such as flipping, new construction for sale, and wholesaling properties.
The purpose of UBIT is to level the playing field and protect tax-paying businesses from unfair competition from tax-exempt entities that are acting like a commercial business. If a tax-exempt entity like an IRA engages in a business such as flipping a property on an infrequent basis, it has not met the “regular or repeated” condition necessary and may not have exposure to UBIT. Unfortunately, there is no distinct guidance from the IRS as to what “regular or repeated” means, so the IRS has a lot of leeway to determine if the type and frequency of transactions crosses that threshold and has UBIT exposure.
When UBIT applies, the IRA or 401(k) will need to file a form 990-T trust tax return to pay the necessary tax due. Trust tax rates apply, and are on a graduated scale, but they top out at 37% with $12,500 of net income after allowable deductions. Many states also have their own parallel version of the tax.
The Impact of UBIT
The following example is a simplified illustration of the possible impact of UBIT on a flip transaction.
|Sales Price after Rehab||$200,000|
|Rehab & Holding Costs||-$50,000|
|After-Tax Net ROI||15%|
The IRA made $23,033 on an investment of $150,000, for a net after-tax ROI of 15%. That is not bad at all, but there are probably less risky means of generating 15% returns to the IRA such as private lending.
Strategies for Avoiding UBIT
Certain activities that qualify as passive are exempted from UBIT, such as interest, dividends, royalties, rent from real property, or the sale of an asset that has been held over time to produce such passive income.
In the past, IRA investors have generally chosen one of two alternative strategies to eliminate exposure to UBIT on home flipping opportunities.
Be the Bank: An IRA can lend money to an unrelated 3rd party engaging in a flip. Such private or hard money loans generate passive interest income not subject to UBIT. The loan must be for fixed points and interest only and may not be structured in such a way that IRA receives profits of the flip. Generally, such loans might be for 1-3 points up front and 10-15% interest depending on factors such as how well you know the borrower, relative risk of the project, loan-to-value amount, timeframe, etc.
Hybrid Flip: With this strategy the IRA acquires a property at discount and adds value via rehab. Rather than immediately capture that added value via a sale and have the transaction considered a trade or business, the property is held as a rental for a period of at least a year. When the property is sold int eh future, this is not viewed as a flip/business and is therefore not subject to UBIT. By shifting focus and being patient, the deal can become much more profitable. Not only will the IRA capture the equity gain in the value of the property without the hit of UBIT, but there may also be net positive cash flow during the rental period.
While both of the above strategies work well within the envelope of a self-directed IRA or Solo 401(k), they are not really “flipping”, and do change the nature of the transaction.
The UBIT Blocker Strategy
A UBIT Blocker is a taxable corporation inserted between a tax-exempt entity and series of transaction that would normally generate UBIT. The blocker does not eliminate taxes, but reduces them to a point where the strategy becomes much more profitable. Instead of flipping profits being taxed at the higher 37% trust tax rate, the new 21% corporate tax rate applies. After tax-profits to the corporation can then be issued as tax-sheltered dividends to the underlying IRA or 401(k) plan.
The concept of a UBIT Blocker has been around for a long time, but was generally only used with very high dollar ventures and often with an off-shore component. When the corporate tax rate was 35%, there was no real benefit for something like house flipping. Now that the top corporate tax rate has been lowered to 21%, there is considerable savings that may be beneficial for investors wanting to flip houses or engage in other trade or business activities with their self-directed retirement plan.
Flipping with a UBIT Blocker
Let’s go ahead and take a look at our sample flip property and see how the numbers work out when using a UBIT Blocker Corporation.
|Sales Price after Rehab||$200,000|
|Rehab & Holding Costs||-$50,000|
|After-Tax Net ROI||18%|
By implementing the blocker strategy, the tax impact of the transaction was reduced by over $3,800. This results in an increased ROI of 18% compared to 15% in the prior case. When you apply such savings over multiple flip transactions in a year, the difference can be significant.
There are several ways a blocker structure can be configured with a Checkbook IRA LLC or Solo 401(k) plan. If the sole purpose will be a business activity such as flipping inside of a Checkbook IRA LLC platform, it may make sense to elect corporate tax treatment for the IRA-owned LLC itself.
If the IRA will do some flipping as well as other passive investments, then forming a separate corporation under the umbrella of the IRA-owned LLC may make more sense. Passive investments take place in the master IRA-LLC while UBIT-exposed transactions would be done inside the sub-entity. A Solo 401(k) trust will always form a separate sub-corporation owned by the 401(k).
The UBIT Blocker strategy changes the tax impact of flipping so that such transactions can make sense in an IRA. The blocker corporation does not, however, change the IRS rules against self-dealing. All investments of a self-directed IRA or Solo 401(k) must be conducted at arm’s length and exclusively for the benefit of the plan. You can administer investments but you or a disqualified party may not provide services to the IRA such as working on an IRA-owned property. That means leave your tool belt at home and ensure that all work on plan-owned properties is conducted by unrelated 3rd parties.
The blocker corporation will need to file state and federal tax returns. You will want to work with your tax professional such as the experts at The Real Estate CPA to perform these filings.
Brian Eastman is a principal and Senior Consultant with Safeguard Advisors, LLC, a leading provider of self-directed IRA and Solo 401(k) plans offering checkbook control. If you have questions about the usage of a self-directed retirement plan for investing in alternative assets such as real estate, please feel free to schedule a consultation.