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How to Flip Homes in a Self‐Directed IRA LLC or Solo 401(k) Plan Tax‐Free
April 9, 2013
Disclaimer: This presentation is intended only as a general discussion of these issues. It is not considered to be legal advice. We would be pleased to provide additional details or advice about specific situations. For additional information on this important topic, please feel free to call upon your IRA Financial Group, LLC relationship partner. No part of this publication may be reproduced, in whole or in part, in any form, without our prior written consent. For further information on the IRA Financial group, LLC, please visit www.irafinancialgroup.com
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Adam Bergman, Esq.• Adam Bergman is a senior tax attorney at the IRA Financial Group, LLC. • Prior to joining the IRA Financial Group, LLC, Mr. Bergman worked as a tax and
ERISA attorney at White & Case LLP, Dewey LeBoeuf LLP, and Thelen LLP, three of the most prominent corporate law firms in the world. He has advised thousands of clients on a wide range of tax and ERISA matters involving limited liability companies and retirement plans for over 10 years.
• Mr. Bergman is recognized as a leading retirement tax‐planning expert and has lectured attorneys on the legal and tax aspects of Self‐Directed IRA LLC and Solo 401(k) Plans.
• Mr. Bergman is a member of the Tax Division of the American Bar Association and New York State Bar Association. Mr. Bergman has been quoted in Forbes, Businessweek, San Franciso Chronicle, Dallas Morning News, Chicago Tribune, USA Today, Daily Business Review, Law.com, and American Lawyer.
• Mr. Bergman received his B.A. (with distinction) from McGill University and his law degree (cum laude) from Syracuse University College of Law. Mr. Bergman also received his Masters of Taxation (LL.M.) from New York University School of Law.
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What is a Self‐Directed IRA LLC with “Checkbook Control”?
• IRS & Tax Court Approved• Can be used with any type of retirement funds
(i.e. IRA, 401(k), 403(b), etc.)• A Limited Liability Company (“LLC”) is created
that is owned by an IRA but managed by the IRA holder giving the IRA holder “checkbook control”over his or her retirement funds
• Using IRA funds to by real estate is as simple as writing a check
• No custodian consent is required when using IRA funds to buy real estate
• No delays using IRA funds to buy real estate• The IRA Holder determines which investments
are appropriate
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What is a Solo 401(K) Plan?
• IRS Approved• 401(k) plans are defined in the Internal Revenue
Code (Section 401) as retirement savings trusts. A Solo 401(k) can be adopted by a sole proprietorship or any LLC, corporation, or partnership with no employees other than the owner(s).
• Trustee directed – “checkbook control” based on plan plan documents
• High contribution limitations ‐$51,000 and $56,500 for individuals over the age of 50
• Loan feature – Borrow up to $50,000 or 50% of your account value, whichever is less
• Minimum administrative requirements
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“Checkbook Control” Advantages• "Checkbook Control": You no longer have to get each investment
approved by the custodian of your account. Instead, all decisions are truly yours. Buying real estate is as easy as writing a check!
• Tax Advantages: You have all the tax advantages of traditional IRA or 401(k) plan, as well as tax deferral and tax‐free gains. All income or gains from the sale of real estate goes back to the retirement tax‐free!
• Investment Options: You can invest in almost any type of investment, including real estate, tax liens, or precious metals!
• Speed:When you find a real estate investment that you want to make with your retirement funds, simply write a check or wire the funds straight from your retirement account bank account to make the investment.
• Retirement & Investment Vehicle All in One: Save for your retirement while gaining the ability to make real estate and other investments without paying tax.
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Why Buy Real Estate Using Retirement Funds?
1.1. Gains are tax freeGains are tax free2.2. Positive cash flow is tax free Positive cash flow is tax free 3.3. No time limit for holding No time limit for holding
propertyproperty4.4. IRA can borrow moneyIRA can borrow money
–– Leverage your Leverage your investment with noninvestment with non‐‐recourse financingrecourse financing
5.5. Potential to earn a larger Potential to earn a larger rate of return on invested rate of return on invested capitalcapital
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Power of Tax Deferral
Tax Deferral: All income and gains generated by your pre‐tax retirement account investment would generally flow back into the retirement account tax‐free.‐Instead of paying tax on the returns of a real estate investment, tax is paid only at a later date, leaving the investment to grow unhindered. ‐investments are usually made when a person is earning higher income and is taxed at a higher tax rate. Withdrawals are made from an investment account when a person is earning little or no income and is taxed at a lower rate.
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Power of Tax‐Free CompoundingTax‐Free Gains: In the case of a Roth IRA or Roth Solo 401(k) Plan, all income and gains generated from a real estate investment would be tax‐free and one can live off that money without ever paying tax.
Example:For example, a 20 year old that invests $10,000 in a Roth IRA orRoth Solo 401(k) Plan today and invests it in Treasury Bills, earning 4% on average for the next 50 years, will find himself or herself with $71,06 of tax‐free funds.
Had he or she invested Roth IRA or Roth Solo 401(k) Plan funds in stocks and real estate, earning a 12% average rate of return as a result of riding out the fluctuations, he or she would haveended up with $2,890,022 in tax‐free funds. Adding higher returning asset classes would result in 40.67 times more money thanks to the power of compound gains.
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Type of Real Estate that can be Purchased Using Retirement Funds
• Below is a partial list of domestic or foreign real estate‐related investments that you can make with retirement funds:
• Raw land • residential homes • Commercial property • Apartments • Duplexes • Condos/townhomes • Mobile homes • Real estate notes • Real estate purchase options • Tax liens certificates • Tax deeds
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Helpful Tips for Buying Real Estate with Retirement Funds
• Make sure that title to the property is held in the name of the IRA LLC or Solo 401(k) Plan. Title should NOT be held in the name of the IRA or the name of the IRA custodian.
• The deposit and entire purchase price should be paid using retirement funds. In certain circumstances, retirement funds may be used alongside other non‐disqualified person funds.
– No personal funds from a disqualified person should be used.• All expenses, repairs, taxes, improvements, etc. should be made using retirement funds. No
personal funds should be used.• If additional funds are required for improvements with respect to the real estate investment,
the additional funds should come from added retirement funds from the custodian or from a non‐disqualified third‐party.
• If financing is needed for an IRA investment, the financing must be nonrecourse (the IRA holder cannot personally guarantee the loan – that would trigger a prohibited transaction).
• All income/gains or losses should flow from the real estate investment directly to the Self‐Directed IRA LLC or Solo 401(k) Plan.
• Work directly with a tax professional who has expertise in the IRS prohibited transaction rules.
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How House Flipping Works‐ Flipping homes with retirement funds is IRS
approved‐ Impact of UBTI
‐ House flipping is, essentially, buying a house or property with the intent to sell it for a profit
‐ Once you know where you want to buy, the next step is deciding what type of property you want to purchase
‐ If you go for a fixer‐upper, you're committing to improving the home, which takes time and money.
‐ If you buy a foreclosed property in an auction or from a bank, you could get a bargain on a vastly underpriced house.
‐ Buy Low, Sell High‐ You want to find a property that is undervalued
or in just bad enough shape that you can invest minimal time and money in it before selling it
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How to Flip Homes With Retirement FundsThe Basics
‐ Take title in the name of the IRA LLC or Solo 401(k) Plan
‐ Pay deposit and purchase price with only retirement funds
‐ Pay for property expenses, improvements, professional fees only with retirement funds
‐ No personal cash can be used in the retirement account real estate transaction
‐ Third‐party non‐disqualified persons should be hired to do all improvements related to the property
‐ All sale proceeds from the home flipping transaction should flow back to the IRA LLC or Solo 401(k) Plan
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Home Flipping With Retirement FundsHome Flipping With Retirement FundsThe ProcessThe Process
•• Establish a selfEstablish a self‐‐directed IRA LLC or Solo 401(k) Plandirected IRA LLC or Solo 401(k) Plan•• Locate a propertyLocate a property•• Remember, itRemember, it’’s the IRA LLC or Solo 401(k) Plan that is s the IRA LLC or Solo 401(k) Plan that is
the buyerthe buyer•• Manager of the LLC or Trustee of the Solo 401(k) Plan Manager of the LLC or Trustee of the Solo 401(k) Plan
will sign will sign ““Offer to PurchaseOffer to Purchase””•• Earnest money deposit made using retirement fundsEarnest money deposit made using retirement funds•• Funds wired to closing from IRA LLC or Solo 401(k) Plan Funds wired to closing from IRA LLC or Solo 401(k) Plan
bank accountbank account•• Fund & RecordFund & Record•• Rents are made payable to your IRA LLC or Solo 401(k) Rents are made payable to your IRA LLC or Solo 401(k)
PlanPlan•• Rents are deposited in IRA LLC or Solo 401(K) Plan Rents are deposited in IRA LLC or Solo 401(K) Plan
bank accountbank account•• Gain from sale of property are deposited in IRA LLC or Gain from sale of property are deposited in IRA LLC or
Solo 401(k) Plan accountSolo 401(k) Plan account
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What are the Limits?
A SelfA Self‐‐Directed IRA or Solo 401(k) Plan can invest in Directed IRA or Solo 401(k) Plan can invest in anything anything
EXCEPTEXCEPTInternal Revenue Code Sections 4975 & 408 prohibit fiduciary and “Disqualified Persons” from engaging in certain types of transactions.1.1. Life Insurance Policies (a Solo 401(k) Plan may purchase life inLife Insurance Policies (a Solo 401(k) Plan may purchase life insurance contracts)surance contracts)2.2. CollectiblesCollectibles3.3. S Corporation StockS Corporation Stock4.4. Any Transaction involving or personally benefitting directly or Any Transaction involving or personally benefitting directly or indirectly a indirectly a ““Disqualified Disqualified
PersonPerson””– Pursuant to IRC 4975, a Disqualified person essentially includes the IRA holder, any
ancestors or lineal descendants of the IRS holder, and entities in which the IRS holder holds a controlling equity or management interest.
• Exceptions: Brother/Sister, Cousin, Aunt/Uncle, Friend
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Real Estate Flipping & IRA Prohibited Real Estate Flipping & IRA Prohibited TransactionsTransactions
•• Neither you nor any disqualified people may benefit from IRA Neither you nor any disqualified people may benefit from IRA –– directly or indirectly directly or indirectly
•• Cannot buy, sell or exchange property between plan and Cannot buy, sell or exchange property between plan and –– Self or Disqualified peopleSelf or Disqualified people–– Buyer nor seller of flipping transaction can be you or any Buyer nor seller of flipping transaction can be you or any disqualified persondisqualified person
•• Cannot provide goods, services or facilities to real estate Cannot provide goods, services or facilities to real estate flipping transactionflipping transaction–– How Involved can I be?How Involved can I be?–– Less is always betterLess is always better
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How to Flip Homes Without Triggering a How to Flip Homes Without Triggering a Prohibited TransactionProhibited Transaction
1.1. Do not buy or sell home to or from yourself or any disqualified Do not buy or sell home to or from yourself or any disqualified personperson2.2. Do not provide any services to your IRA owned real estateDo not provide any services to your IRA owned real estate
1.1. Do not perform any improvements Do not perform any improvements –– pay a thirdpay a third‐‐party nonparty non‐‐disqualified person for all work using retirement funds disqualified person for all work using retirement funds –– this this includes any major improvement like a roof to any minor expense includes any major improvement like a roof to any minor expense such as landscapingsuch as landscaping
2.2. Do not use any personal funds to pay any real estate related Do not use any personal funds to pay any real estate related expensesexpenses
3.3. Do not serve as listing broker on the transactionDo not serve as listing broker on the transaction4.4. Do not perform any marketing services with respect to the real Do not perform any marketing services with respect to the real estate saleestate sale
5.5. All closing costs should be paid with retirement accountsAll closing costs should be paid with retirement accounts
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What is UBTI?What is UBTI?• The tax advantage of an IRA or 401(k) is that income is tax‐free until distributed.• To prevent tax‐exempt entities from competing unfairly with taxable entities, tax‐
exempt entities are subject to unrelated business taxable income (UBTI) when their income is derived from any trade or business that is unrelated to its tax‐exempt status.
• UBTI is defined as “gross income derived by any organization from any unrelated trade or business regularly carried on by it” reduced by deductions directly connected with the business.
• An exempt organization that is a limited partner, member of a LLC, or member of another non‐corporate entity will have attributed to the UBTI of the enterprise as if it were the direct recipient of its share of the entity's income, which would be UBTI had it carried on the business of the entity.
• UBTI also applies to unrelated debt‐financed income used for the purchase of real property (UDFI).
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UBTI Exceptions?UBTI Exceptions?
• The majority of income generated by a Self‐Directed IRA or Solo 401(k) Plan is exempt from UBTI.
• Dividends, interest, annuities, royalties, most rentals from real estate, and gains/losses from the sale of real estate.
• Note ‐ rental income generated from real estate that is “debt financed” loses the exclusion.
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What type of Retirement transactions may trigger the UBTI tax?
• Most passive investments that your Self Directed IRA LLC or Solo 401(k) Plan might invest in are exempt from UBTI.
• The UBTI generally applies to the taxable income of “any unrelated trade or business…regularly carried on” by an organization subject to the tax. The regulations separately treat three aspects of the quoted words—“trade or business,” “regularly carried on,” and “unrelated.”
• Trade or Business: “trade or business” to profit‐oriented endeavors involving regular activity by the taxpayer.
• Regularly Carried On: The UBIT only applies to income of an unrelated trade or business that is “regularly carried on” by an organization. Whether a trade or business is regularly carried on is determined in light of the underlying objective to reach activities competitive with taxable businesses. The requirement thus is met by activities that “manifest a frequency and continuity, and are pursued in a manner generally similar to comparable commercial activities of nonexempt organizations. ”
• For an IRA or Solo 401(k) Plan, any active business regularly carried on or by a partnership or LLC of which it is a member is an unrelated business.
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The Taxation of Flipping Real Estate The Taxation of Flipping Real Estate The BasicsThe Basics
• The majority of income generated by a Self‐Directed IRA or Solo 401(K) Plan is exempt from UBTI.
• Dividends, interest, annuities, royalties, most rentals from real estate, and gains/losses from the sale of real estate.
– Note ‐ rental income generated from real estate that is “debt financed” loses the exclusion.
• Gains from the sale of real estate will generally be tax‐deferred – tax‐free in the case of a Roth IRA or Roth Solo 401(k) Plan.
• What about multiple real estate purchases in a year?– Does this trigger UBTI?
• Passive vs. active business (inventory)• Facts and circumstances test• No set number• Case law
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Flipping Real Estate & UBTIFlipping Real Estate & UBTI
• Flipping homes Vs. rental properties– Active Vs. Passive
• How many home flipping transactions in a year are permitted without triggering UBTI?– Facts and circumstances test– IRS has not provided a set number – Case law
• 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 Tax Court has set forth a number of factors in determining whether the taxpayer was engaged in the operation of a trade or business.
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Factors to Determine Whether a Flipping Factors to Determine Whether a Flipping Transaction Triggers UBTITransaction Triggers UBTI
• 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• This factor is particularly significant in determining whether the sale constitutes a trade or business that is
regularly carried on, within the meaning of Internal Revenue Code Section 512. It may range from a one‐time sale of a parcel of land to many sales over a long period. If sales are infrequent, not continuous, and small, the organization will not likely be viewed as similar to a taxpayer in the trade or business of selling real estate.
– PLR 9247038, the IRS issued a favorable ruling to an organization that planned to sell land in up to 15 sales spread over a five‐ to 10‐year period. The reason for the number of sales over the time period was that the value of the land was such that it was unlikely a single purchaser would be able to acquire the entire parcel. Also, market conditions dictated this sales process for the organization to receive maximum value, and keep control of the pace and type of development that would occur after the sales.
– PLR 9017058, where the exempt organization was engaged in selling 45 of 68 lots, such sales were deemed to meet the exception from unrelated business income under Internal Revenue Code Section 512(b)(5). Although this quantity of sales is admittedly significant, external forces essentially dictated the high number of sales. The organization first tried to sell the property in one block but was unsuccessful due to the high cost of developing the property in order to comply with local ordinances.
• a limited number of sales is usually a “good fact” for purposes of the facts and circumstances test.
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Factors to Determine Whether a Flipping Factors to Determine Whether a Flipping Transaction Triggers UBTITransaction Triggers UBTI
‐ The activities of the seller in the improvement and disposition of the property: The smaller the extent of improvements by the organization to the property, the more likely the sale will fall under the exclusion.‐ PLR 8043052, an organization proposed to sell a parcel of undeveloped raw
land . The fact that the land had remained undeveloped was significant in determining that gains from the proposed transaction would not constitute unrelated business taxable income.
‐ PLR 8522042, the property in question consisted of both developed and undeveloped lands. The developed lands included residential land improved with single‐family dwellings or condominium apartments. However, all the improvements were constructed by unrelated third parties. The absence of development activity by the organization demonstrated that it was not holding property for sale to customers in the ordinary course of trade or business.
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Factors to Determine Whether a Flipping Factors to Determine Whether a Flipping Transaction Triggers UBTITransaction Triggers UBTI
‐ The extent of improvements made to the property: The more minimal the activities of the owner in improving and disposing of property, the more likely its sale will meet the exclusion from unrelated business taxable income under Internal Revenue Code Section 512(b)(5).
‐ The IRS ruled favorably on improvements made to property in accordance with city or local ordinances requiring the organization to construct a street as well as curb, gutter, sidewalk, drainage, and water supply improvements in order to subdivide the property for sale.
‐ In PLR 8950072, a tax‐exempt foundation's largest asset was a parcel of unimproved real estate. The foundation was examining four ways of using the property: (1) continue leasing the property; (2) sell the property as is; (3) complete some preliminary development work — obtaining permits and approvals — and sell the property; or (4) completely develop the property before sale. The last alternative would provide the highest return. The IRS ruled that the first three alternatives would not subject the foundation to UBIT or adversely affect its exempt status. However, the last alternative, to assume all the responsibilities of development, would result in UBTI, but would not affect the foundation's exempt status.
‐ Brown v. Comr., the taxpayer intended to subdivide and develop the property for sale to the general public. Such sales would not be isolated or casual transactions. The organization planned to be extensively involved in both development and marketing activities. Thus, the IRS concluded that the property will be held primarily for sale to customers in the ordinary course of trade or business and not subject to the exclusion.
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Factors to Determine Whether a Flipping Factors to Determine Whether a Flipping Transaction Triggers UBTITransaction Triggers UBTI
‐ The proximity of sale to purchase ‐generally the longer the period between purchase and sale, the more likely the sale will be excluded from UBTI.‐ PLR 9505020, the fact that a school received land
by bequest and held it for a significant period of time was considered a favorable factor, and the IRS did not impose UBIT on the sale of the land when the school was facing condemnation proceedings and it did not actively advertise the sale.
‐ The purpose for which the property was held during the taxable year
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What UBTI Factor Matters Most to the IRS?What UBTI Factor Matters Most to the IRS?
‐ In Adam v. Comr. and subsequent cases, the Tax Court found that no single factor is controlling but all are relevant facts to consider in determining whether the sale of property occurred in the regularcourse of the taxpayer's business. In numerous private letter rulings, the IRS cites and applies these same “Adam” factors. The IRS has characterized these factors as a “facts and circumstances test.”
‐ Less is always better‐ Goal is to show flipping transactions are passive and not an active
business‐ Investment vs. inventory
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Flipping Homes Flipping Homes ‐‐ Tips to Avoid UBTITips to Avoid UBTI
‐ Less is always better‐ Try to space out flipping transactions
‐ Between transactions‐ Between years
‐ Between flipping transaction try to diversify investments‐ Stocks, gold, etc.
‐ The less amount of improvements you do the better‐ Rent out properties or at least attempt to, if possible‐ Have other retirement investments from the same account if
possible‐ Stocks, mutual funds, long term real estate, etc.
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Flipping Homes Flipping Homes –– Can I Use Leverage?Can I Use Leverage?
‐ The IRS permits the use of nonrecourse leverage ONLY for investments involving retirement funds‐ No personal guarantee‐ Not a typical mortgage
‐ UBTI also applies to unrelated debt‐financed income used for the purchase of real property (UDFI)‐ Exception for Solo 401(K) Plans – UBTI tax does not apply if Solo 401(K) Plan used
nonrecourse leverage for a real estate acquisition‐ UBTI tax rate is approximately 35% (trust tax rates)‐ In general, UBTI tax is imposed on debt‐financed portion of property, taking into account
expenses, such as depreciation ‐ The UBTI tax on IRA LLCs using leverage can significantly change economics of transaction
‐ Need to consider impact on your investment returns
‐ Flipping homes with cash avoids UBTI
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• Attorney owned and operated• Market’s leading Self Directed IRA LLC and Solo 401(k)
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process can be handled by phone, email, fax, or mail. Our expert tax and ERISA attorneys are on‐site greatly reducing the set‐up time and cost.
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