Tag Archives: UDFI

Health Savings Accounts, Self-Directed 401(k), Self-Directed IRA & Qualified Plan Information, Self-Directed Roth IRA, Self-Directed Traditional IRAs

UBIT? You Bet!

Questions:

I think the answer to my question. Does Arkansas charge tax on UBIT and UDFI?

in the book 2009 Multistate Guide to Regulation and Taxation of Nonprofits By Steven D. Simpson. Which is found in full online through google books at:

https://books.google.com/books?id=KE5dVpNcWkwC&pg=SA3-PA9&lpg=SA3-PA9&dq=Section+512+of+the+Internal+Revenue+Code+arkansas&source=bl&ots=YFNc-ZE7U0&sig=PpYxNwFJEhq5fd920ha18OXLFkw&hl=en&sa=X&ei=ItEKVdmUOcSwggSMiIOoBQ&ved=0CC8Q6AEwAw#v=onepage&q=Section%20512%20of%20the%20Internal%20Revenue%20Code%20arkansas&f=false

It says that Arkansas does not have IRS code sections 501-529, but that it does tax unrelated business income on income attributable to Arkansas. Since UDFI is Section 514 I assume that there is no state income tax on UDFI. I also believe that attributable to Arkansas means the source of the income is physically inside the state.

This book seems to be a source of answers on UDFI and UBIT for all 50 states or at least a starting place.

I still have the following 3 questions from yesterday in a more simplified form:

 

1) If you pay UDFI on the sale of a depreciated rental property do you also recapture depreciation at a 25% rate?

 

2) If my IRA purchases a condo for nightly rental using debt will it owe UBIT on the nightly rental and UDFI on the profit percentage of the debt?

 

3) In the following  published article you state that UDFI is on Acquisition debt. Does this infer that if I pay cash for the house and then borrow against it later there is no UDFI? In other words is UDFI on all debt or just aquisition debt.

 

https://www.questira.com/why-your-ira-may-owe-taxes-to-pay-or-not-to-pay-that-is-the-question/

 

Definition of “Debt Financed Property.” In general, the term “debt-financed property” means any property held to produce income (including gain from its

disposition) for which there is an acquisition indebtedness at any time during the taxable year (or during the 12-month period before the date of the property’s disposal if it was disposed of during the tax year). If your retirement plan invests in a non-taxable entity and that entity owns debt financed property, the income from that property is attributed to the retirement plan, whether or not the income is distributed.

 

 

Answer:

 

Thanks for the reference and the questions yesterday. Sorry we couldn’t get to all of them on the call.  As far as your questions:

1) I believe the IRA would owe this tax, but I have heard different arguments on this. If you think about it, it wouldn’t make sense to be able to deduct depreciation from current UDFI and then escape it on the sale of the property. However, one CPA told me that if the property had been paid off for more than 12 months so there was no capital gains tax then there wouldn’t be depreciation recapture either. I think this was based on the theory that ‘depreciation recapture’ is really another form of capital gains, technically called ‘unrecaptured section 1250 gains.’ To be honest, I just don’t know.

2) That’s a good question. Certainly running a hotel is considered to be a business operation as opposed to just rental income, so I see where you could assume that the nightly rentals would be UBI and not UDFI. I think that if it is considered to be a business operation then probably all income from that business would be UBI not UDFI. I don’t think you can split the capital gains in that case away and call them UDFI, but once again I’m really not that confident, especially this early in the morning. On the other hand, if it were me I would probably just report it as UDFI and see if the IRS disagreed. There is a lot of ambiguity in this area, unfortunately.

 

3) Another good question, but this one I can actually help you with. 🙂 Acquisition indebtedness is 1) when acquring or improving the property; 2) before acquring or improving the property if the debt would not have been incurred except for the acquisition or improvement; or 3) after acquiring or improving the property if (a) the debt would not have been incurred except for the acquisition or improvement, and b) incurring the debt was reasonably forseeable when the property was acquired or improved. So most likely in your scenario the debt would still be considered ‘acquisition indebtedness.’

 

Here is an interesting brain twister: what if my IRA owns a piece of land with no debt which produces no income but which is expected to be sold within a year. If my IRA borrows money to purchase bank stock, which will not be sold for several years, which property is considered debt-financed, the land or the bank stock? If the answer is the bank stock, then can my IRA escape taxation entirely on the gains from the bank stock because the debt will have been paid off from the sales proceeds of the land for more than 12 months prior to the sale of the bank stock?

Self-Directed 401(k), Self-Directed IRA & Qualified Plan Information

Debt Financed Property in a Self-Directed 401(k) and UBIT

Question: I attended the seminar with you, Dyches Boddiford, and Hugh Bromma about a year ago.  I was reading the transcript of your February 4 radio interview which was very interesting.  You mentioned the need to file a 990T for your 401K with regard to a debt financed shopping center that your plan owns.  I wondered if that is correct because I thought it was unnecessary to file a 990T for a 401K, especially since there is no UDFI tax on a 401K.  Is there an advantage to filing one in such a situation?

Any insight you could give me on this would be much appreciated.  I have a debt financed property in my 401K so this is a particular topic of interest to me.

Answer:  Yes, the information about the 990T is correct in this case.  The exception you refer to requires either direct ownership by the 401(k), ownership through a special type of corporation, or ownership through a specially designed partnership.  Since most partnerships where non-retirement plans are also partners do not meet the special requirements to maintain the exemption, as mine does not, your plan may still owe UBIT and have to file a 990T.  As noted in the interview, this can still work out great, but you should always go in with your eyes open.  And yes, even if you do not owe UBIT taxes filing the 990T may be of some benefit, since you can carry forward a loss to offset future UBIT from the investment.  For the past two years the partnership my 401(k) invested in has shown a slight loss, but this year it will show a fairly decent profit, and I will use my loss carry forward from the last couple of years to offset the tax.

I have some articles I wrote on the topic, but right now I am in an airport on my way to Florida, so I can’t access them.  I will be back in the office next Wednesday.  The exemption and the restrictions on it may be found in Internal Revenue Code Section 514(c)(9).

I hope that helps some.  Have a great weekend!

H. Quincy Long’s UBIT Paper

Self-Directed IRA & Qualified Plan Information, Self-Directed Roth IRA, Self-Directed Traditional IRAs

Does Flipping Notes, Loans or Homes Create UBIT?

Conversation Between 2 Persons: Gentleman, The debate continues:)  I actually have an account with ….  I use this company website as a resource: But, it does not seem to give much information regarding the the tax treatment of Flipping notes in an IRA:  I am networking with a lot of younger investors and there seems to be a lot of questions and little information.  When we ask our tax professionals they “look at us like-you can’t do that.”  Most tax and legal professionals do not seem to understand much, if anything about Self Directed Investing.  So here is a follow up to the conversation if you can help us clear this up.  Just to put this into context, the original question was, “what would you do with $50k in a Self Directed IRA.”  I would say the average reader is in their late 30’s.

Person 1: I find it very hard to believe that flipping notes could be considered appreciably different than transacting stocks quickly.

Person 2: I don’t think we are saying that they are “appreciably” different, just that the two investment options (stocks on public market vs. private market notes) are different in other means. I have no idea which is the correct and legal answer, but in my opinion, I see how one can argue that notes sold/transfered from flipping which deal with a buyer and a seller who negotiate between themselves and have contact between them in a private manner is functionally different than flipping stocks in a public market where the buyer and seller never negotiate and never have contact.

To add to the confusion, what if you bought and immediately sold an actual business inside your 401k/IRA. Would UBIT apply?

Person 1: Flipping stocks doesn’t just magically occur either. A buyer and a seller still have to agree on a price for a transaction to occur. There may be fewer things to negotiate in these transactions, but I don’t see how they are really different from a “business standpoint.” What about trading something on the pink sheets? Is that somehow different still?

Person 2: I almost always agree with you, but will have to agree to disagree on this. Regardless of who is right, as no final evidence has been discovered clearly (and may never be clear), we just have two different thoughts on this. I see a difference in stocks vs. flipping notes as explained, you do not as explained. No problem.  Not only that, when they discuss the fact that the IRA can use debt leverage on a rehab, it makes no mention of UDFI which also triggers UBIT (unless debt is paid off 365 days before sale). As I have mentioned in the past, unfortunately, find details are often missing from TPA’s such as Equity Trust.

It seems like there is a lot of mis information and confusion out there regarding the subject.  I certainly appreciate your thoughts, time and any information you can cite to help us clear this up.  Please note that am not asking for advice-just information on where we can find facts in regards to this subject.

Quincy’s Answer: I think you’re trying to over analyze this and impose rationality and reason on the US government, which is of course quite impossible.  Step back and ask yourself one question while forgetting entirely about the IRA aspect of it – would note flipping be considered a trade or business if you did it personally?  If the answer is yes, then it is, by definition, a trade or business within the IRA as well, and it will generate UBIT, assuming it is “regularly carried on.”  If the answer is no, then it should not generate UBIT.  Whether something else like day trading stocks is or isn’t a trade or business is irrelevant.  You are focusing on the IRA aspect of it when you should be focusing on whether or not it is a trade or business.  In general terms, anything that you buy as “inventory” for resale to the public is going to be considered a trade or business, whether it is real estate, notes, widgets or anything else.  Unfortunately, the standard of when you cross the line from being an investor to being in a trade or business is fuzzy at best and depends on many factors.  Oh well, that’s the world we live in.

I have attached my short paper on UBIT.  You may also find more information on UBIT in IRS Publication 598.  The Internal Revenue Code sections dealing with UBIT are 26 USC 511-514.  I hope that helps some.  Good luck!

Full H. Quincy Long UBIT White Paper

Person 2: Thank you for taking the time to help me out with this.  It seems to me that it is best t err on the side of caution with this since the penalties can be so steep.  I see a lot of guys buying and flipping homes in IRA’s.  These guys are considered “Dealers” because they also buy and flip properties outside of IRA’s.  I would say since these are bought with the intention of immediately offering them for sale to the public that they would then be subject to UBIT.  The same would hold tru for a note that is immediately flipped.  When you say “regulatory carried on,” do you mean this is something you do inside the IRA X amount of times per year, X amount of times during the life if the IRA?      

Quincy’s Answer: Review Page 3 of IRS Publication 598, which states:  “Business activities of an exempt organization ordinarily are considered regularly carried on if they show a frequency and continuity, and are pursued in a manner similar to comparable commercial activities of nonexempt organizations.”  An example is given in the publication.  I agree that intent is very important.  I’m not sure that an occasional flip in an IRA among many other investments will cause UBIT, but certainly if that’s all that the IRA invests in and the IRA owner also flips properties outside of his or her IRA that would weigh heavily in the consideration of whether the IRA had dealer income.  While IRAs are very rarely audited, it is always important to give the IRS what they are due, because they have what it takes to take what you have.

One thing I would caution you about is not to confuse the payment of UBIT with the penalties associated with prohibited transactions.  It is perfectly legal to make investments which subject your IRA to taxation, but if you do a prohibited transaction it blows up your entire IRA and you and others may owe excise taxes and penalties as well.  The two subjects are completely separate, but many people, even educated ones, get them mixed together in their minds.

Self-Directed Roth IRA, Self-Directed Traditional IRAs

The Truth About Self-Directed IRAs and Other Accounts

By H. Quincy Long

There is a lot of confusion over self-directed IRAs and what is and is not possible.In this article we will disprove some of the more common self-directed IRA myths.

Myth #1 – Purchasing anything other than CDs, stocks, mutual funds or annuities is illegal in an IRA.

Truth:The only prohibitions contained in the Internal Revenue Code for IRAs are investments in life insurance contracts and in “collectibles”, which are defined to include any work of art, any rug or antique, any metal or gem (with certain exceptions for gold, silver, platinum or palladium bullion), any stamp or coin (with certain exceptions for gold, silver, or platinum coins issued by the United States or under the laws of any State), any alcoholic beverage, or any other tangible personal property specified by the Secretary of the Treasury (no other property has been specified as of this date).

Since there are so few restrictions contained in the law, almost anything else which can be documented can be purchased in your IRA.A “self-directed” IRA allows any investment not expressly prohibited by law.Common investment choices include real estate, both domestic and foreign, options, secured and unsecured notes, including first and second liens against real estate, C corporation stock, limited liability companies, limited partnerships, trusts and a whole lot more.

Myth #2 – Only Roth IRAs can be self-directed.

Truth: Because of the power of tax free wealth accumulation in a self-directed Roth IRA, many articles are written on how to use a Roth IRA to invest in non-traditional investments.As a result, it is a surprisingly common misconception that a Roth IRA is the only account which can be self-directed.In fact, there are seven different types of accounts which can be self-directed.They are the 1) Roth IRA, 2) the Traditional IRA, 3) the SEP IRA, 4) the SIMPLE IRA, 5) the Individual 401(k), including the Roth 401(k), 6) the Coverdell Education Savings Account (ESA, formerly known as the Education IRA), and 7) the Health Savings Account (HSA).Not only can all of these accounts invest in non-traditional investments as indicated in Myth #1, but they can be combined together to purchase a single investment.

Myth #3 – I don’t qualify for a self-directed Roth or Traditional IRA because I am covered by a retirement plan at work or because I make too much money.

Truth:Almost anyone can have a self-directed account of some type.Although there are income limits for contributing to a Roth IRA (in 2008 the income limits are $169,000 for a married couple filing jointly and $116,000 for a single person or head of household), having a plan at work does not affect your ability to contribute to a Roth IRA, and there is no age limit either.With a Traditional IRA, you or your spouse having a retirement plan at work does affect the deductibility of your contribution, but anyone with earned income who is under age 70 1/2 can contribute to a Traditional IRA.There are no upper income limits for contributing to a Traditional IRA.Also, a Traditional IRA can receive funds from a prior employer’s 401(k) or other qualified plan.Additionally, you may be able to contribute to a Coverdell ESA for your children or grandchildren, nieces, nephews or even my children, if you are so inclined.If you have the right type of health insurance, called a High Deductible Health Plan, you can contribute to an HSA regardless of your income level.With an HSA, you may deduct your contributions to the account and qualified distributions are tax free forever!It’s the best of both worlds.All of this is in addition to any retirement plan you have at your job or for your self-employed business.

Myth #4 – I can’t have a self-directed 401(k) plan for my business because I am self-employed and file a Schedule C for my income.

Truth:You can have a self-directed SEP IRA, a SIMPLE IRA or a 401(k) plan even if you are self-employed and file your income on Schedule C of your personal tax return.With a SEP IRA, you can contribute up to 20% of your net earnings from self-employment (calculated by deducting one-half of your self-employment tax from your net profits as shown on Schedule C) or 25% of your wages from an employer, up to a maximum of $46,000 for 2008.With the SIMPLE IRA, you can defer up to the first $10,500 of your net earnings from self-employment (calculated by multiplying your net Schedule C income by 0.9235% for SIMPLE IRA purposes), plus an additional $2,500 of your net earnings if you are age 50 by the end of the year, plus you can contribute an additional 3% of your net earnings as an employer contribution.Beginning in 2002 even self-employed persons are entitled to have their own 401(k) plan.Better yet, in 2006 the Roth 401(k) was added, allowing even high income earners to contribute after tax dollars into an account where qualified distributions are tax free forever!With an Individual 401(k) you can defer up to $15,500 (for 2007 and 2008) of your net earnings from self-employment (calculated by deducting one-half of your self-employment tax from your net profits as shown on Schedule C), plus an additional $5,000 of your net earnings if you reach age 50 by the end of the year, plus you can contribute as much as an additional $30,500 based on up to 20% of your net earnings for2008 (or 25% of your wages from an employer).This means that a 50 plus year old self-employed person can contribute up to $51,000 for 2008!

Myth #5 – Because I have a small IRA and can only contribute $5,000, it’s not worth having a self-directed IRA.

Truth:Even small balance accounts can participate in non-traditional investing.Small balance accounts can be co-invested with larger accounts owned by you or even other people.For example, one recent hard money loan we funded had 10 different accounts participating.The smallest account to participate was for only $1,827.00!There are at least 4 ways you can participate in real estate investment even with a small IRA.First, you can wholesale property.You simply put the contract in the name of your IRA instead of your name.The earnest money comes from the IRA.When you assign the contract, the assignment fee goes back into your IRA.If using a Roth IRA, this profit is tax-free forever!Second, you can purchase an option on real estate, which then can be either exercised, assigned to a third party, or canceled for a fee.Third, you can purchase property in your IRA subject to existing financing or with a non-recourse loan from a bank, a hard money lender, a financial friend or a motivated seller.Profits from debt-financed property in your IRA may incur unrelated business income tax (UBIT), however.Finally, as mentioned above, your IRA can be a partner with other IRA or non-IRA investors.

Myth # 6 – If I want to purchase non-traditional investments in an IRA, I must first establish an LLC which will be owned by my IRA.

Truth:A very popular idea in the marketplace right now is that you can invest your IRA in an LLC where you (the IRA owner) are the manager of the LLC.Effectively you have “checkbook control” of your IRA funds.Providers generally charge thousands of dollars to set up these LLCs and sometimes mislead people into thinking that this is necessary to invest in real estate or other non-traditional investments.This is simply not true.Not only can an IRA hold title to real estate and other non-traditional investments directly with companies such as Quest IRA, Inc., but having “checkbook control” of your IRA funds through an LLC can lead to many traps for the unwary.Far from protecting your IRA from the prohibited transaction rules, these setups may in fact lead to an inadvertent prohibited transaction, which may cause your IRA to be distributed to you, sometimes with substantial penalties.This is not to say that there are not times when having your IRA make an investment through an LLC is a good idea, especially for asset protection purposes.Nonetheless, you must educate yourself completely as to the rules before deciding on this route.Having a “checkbook control” IRA owned LLC is kind of like skydiving without a parachute – it may be fun on the way down, but eventually you are likely to go SPLAT!

Myth #7 – I can borrow money from my IRA to purchase a vacation home for myself.

Truth:Although the Internal Revenue Code lists very few investment restrictions, certain transactions (as opposed to investments) are considered to be prohibited.If your IRA enters into a prohibited transaction, there are severe consequences, so it is important to understand what constitutes a prohibited transaction.

Essentially, the prohibited transaction rules were made to discourage disqualified persons from dealing with the assets of the plan in a self-dealing manner, either directly or indirectly. The assets of a plan are to be invested in a manner which benefits the plan itself and not the IRA owner (other than as a beneficiary of the IRA) or any other disqualified person.Investment transactions are supposed to be on an arms length basis.

As a result of these legal restrictions, a loan from your IRA or staying at a vacation home owned by your IRA, even if fair market rates are paid for interest or rent, would be prohibited.

Myth #8 – With a self-directed IRA, I can borrow my IRA funds to purchase real estate and then put all the profits back into the IRA.

Truth:When real estate or any other asset is purchased within a self-directed IRA, the money never leaves the IRA at all.Instead, the IRA exchanges cash for the asset, in the same way that an IRA at a brokerage house exchanges cash for shares of stock or a mutual fund.Therefore, the asset must be held in the name of the IRA.For example, if Max N. Vestor were to purchase an investment house in his self-directed IRA, the title would be held as “Quest IRA, Inc. FBO Max N. Vestor IRA #12345-11.”Since the IRA owns the asset, all expenses associated with the asset must be paid by the IRA and all profit resulting from that investment belongs to the IRA, including rents received and gains from the sale of the asset.

Myth #9 – If my IRA buys real estate, it must pay all cash for the property.An IRA cannot buy real estate with debt.

Truth:An IRA can own debt-financed property, either directly or indirectly through a non-taxed entity such as an LLC or partnership.Any debt must be non-recourse to the IRA and to any disqualified person.An IRA may have to pay Unrelated Debt Financed Income Tax (UDFIT) on its profits from debt-financed property.In general, taxes must be paid on profits from an IRA-owned property that is debt-financed, including profits from the sale or disposition of the property, in the same proportion that it had debt.For a simplified example, if the IRA puts 50% down, then 50% of its profits above $1,000 will be taxable.Although at first this sounds terrible, in fact leverage can be an extremely powerful tool in building your retirement wealth.The same leverage principle applies inside or outside of your IRA – you can do more with debt-financing than you can without it.One client was able to build her Roth IRA from $3,000 to over $33,000 in less than 4 months even after paying the taxes due by taking over a property subject to a debt and selling the property to another investor!

Myth #10 – An IRA cannot own a business.

Truth:A self-directed IRA is an amazingly flexible wealth building tool and can own almost anything, including a business.However, due to the conflict of interest rules you cannot work for a business owned by your IRA and get paid.Some companies have a plan to start a C corporation, adopt a 401(k) plan, roll an IRA into the 401(k) plan and purchase employer securities to effectively start a new business, but this is not a direct investment by the IRA in the business and is fairly expensive to set up.Also, if your IRA owns an interest in a business, either directly or indirectly through a non-taxed entity such as an LLC or partnership, the IRA may owe Unrelated Business Income Tax (UBIT) on its profits from the business.A solution to this problem may be to have the business owned by a C corporation or another taxable entity.

Self-Directed Roth IRA, Self-Directed Traditional IRAs

Option Strategies for Your IRA

Many people would like to buy real estate in their IRAs but have a mistaken belief that they do not have enough money to do so.  Nothing could be further from the truth!  You may invest in real estate with your IRA without a lot of money in several ways, including partnering with other IRAs or non-IRA money, buying property with debt, or by using one of the most powerful and under utilized tools in real estate investing today – the option.

In this article we will focus on some option basics.  First, what is an option?  Once consideration for the option is paid, it is the owner’s irrevocable offer to sell the property to a buyer under the terms of the option for a certain period of time.  The buyer has the right but not the obligation to buy.

You might wonder why an owner would agree to tie up his property with an option.  Advantages to a property owner include:  1) the owner may be able to time his income for tax purposes, since option fees are generally taxable when the option is either exercised or expires (always check with your tax advisor); 2) if the owner needs money, an option may be a way to get money that he doesn’t have to repay, unlike a loan; 3) options are very flexible, and the owner may be able to negotiate an option which allows him to keep the property until a more opportune time – this is especially true of an owner in a pre-foreclosure situation.

Do the paperwork right!  Options are extremely powerful and very easy to mess up.  Be very specific, clear and complete about all the details.  Remember, with options, you have to negotiate for both the option and for the purchase of the property. With a well written option, the following must be, as my old law professor was fond of saying, “patently obvious to the most casual observer”:

a)         Who is granting the option?  Does it include heirs, successors and assigns?
b)         Who is receiving the option?  Does it include assignees of the buyer, or is it an exclusive option to purchase by the buyer only?
c)         What property is being optioned?  Property can be anything, including real estate, a beneficial interest in a land trust, a real estate note or nearly anything else.
d)         What is the consideration for the option?  Remember, there must be some consideration for the option in the form of money, services or other obligations.
e)         How is the option exercised by the buyer?  This is one of the easiest things to mess up in an option.  If the procedure is not clear for exercising the option, it is an invitation to litigation!
f)          What will be the purchase price of the property if the option is exercised?
g)         How will the purchase price be paid when the option is exercised?  Will it be for cash?  Seller financing?  Subject to the owner’s existing mortgage?
h)         Will the option consideration be credited to the option price or not?
i)          When can the option be exercised?  For example, does the option holder have the right to exercise the option at any time during the option period, or can the option only be exercised after a specified amount of time?
j)          When will the option expire, and under what circumstances?  The option should have a definite termination date, but might also include other circumstances under which the option terminates, such as a default under a lease.
k)         When it comes time to close, what are each party’s obligations?  For example, who pays for title insurance, closing costs, etc?  Are taxes prorated?

So what forms do you use?  The answer is my favorite as a lawyer – it depends! There is not and cannot be a “standard” option for all purposes.  They are simply too flexible.  You must decide on a specific use for the option and then, as Shakespeare said, “Get thee to a lawyer!” (Okay, it was “Get thee to a nunnery” but I like it better as revised!).

When you have negotiated an option agreement for your IRA, you have several choices.  First, you can let the option expire on its own terms.  Sometimes this is the best course of action if the deal is not what you expected, especially if you only paid a small amount for the option.

Another choice is that your IRA could exercise the option and buy the property.  Since there are ways to finance property being purchased by your IRA, including seller financing, bank financing, private party financing or even taking over property subject to a loan, this may be a good strategy for your IRA, even if the IRA does not have the cash to complete the purchase.  Be aware that if your IRA owns debt financed property, either directly or indirectly through an LLC or partnership, its profits from that investment will be subject to Unrelated Business Income Tax (UBIT).  This is not necessarily a bad way to build your retirement wealth, but it does require some understanding of the tax implications.

A third choice which is often employed in the context of self directed retirement accounts is to assign your option to a third party for a fee.  Your option agreement should specifically allow for an assignment to make sure that there are no problems with the property owner.  This is a great technique for building a small IRA into a large IRA quickly.  I had one client who put a contract on a burned house for $100 earnest money in his daughter’s Coverdell Education Savings Account, then sold his contract to a third party who specialized in repairing burned houses for $8,500.  In under 1 month the account made a profit of 8,400%, and all parties were happy with the deal!  The account holder then immediately took a TAX FREE distribution to pay for his daughter’s private school tuition.

A fourth choice that sometimes is overlooked is the ability to release the option back to the property owner for a cancellation fee.  In other words, this is a way for your IRA to get paid not to buy! Let me give you an example of how this might work.  Suppose you want to offer the seller what he would consider to be a ridiculously low offer.  When the seller balks, you say “I’ll tell you what.  You sign this option agreement for my IRA to purchase this property at my price, and we’ll put in the option agreement that I cannot exercise my option for 30 days.  If you find a buyer willing to offer you more money within that 30 day period, just reimburse my IRA the option fee plus a cancellation fee of $2,500.”  Either way, your IRA wins!

The creative use of options can make your IRA grow astronomically if done correctly.  In future articles I will be discussing different types of option strategies.

Self-Directed Traditional IRAs

The Truth About Self-Directed IRAs and Other Accounts

There is a lot of confusion over self-directed IRAs and what is and is not possible.  In this article we will disprove some of the more common self-directed IRA myths.

Myth #1. Purchasing anything other than CDs, stocks, mutual funds or annuities is illegal in an IRA.

Truth:

The only prohibitions contained in the Internal Revenue Code for IRAs are investments in life insurance contracts and in “collectibles”, which are defined to include any work of art, any rug or antique, any metal or gem (with certain exceptions for gold, silver, platinum or palladium bullion), any stamp or coin (with certain exceptions for gold, silver, or platinum coins issued by the United States or under the laws of any State), any alcoholic beverage, or any other tangible personal property specified by the Secretary of the Treasury (no other property has been specified as of this date).

Since there are so few restrictions contained in the law, almost anything else which can be documented can be purchased in your IRA.  A “self-directed” IRA allows any investment not expressly prohibited by law.  Common investment choices include real estate, both domestic and foreign, options, secured and unsecured notes, including first and second liens against real estate, C corporation stock, limited liability companies, limited partnerships, trusts and a whole lot more.

Myth #2. Only Roth IRAs can be self-directed.

Truth:

Because of the power of tax free wealth accumulation in a self-directed Roth IRA, many articles are written on how to use a Roth IRA to invest in non-traditional investments.  As a result, it is a surprisingly common misconception that a Roth IRA is the only account which can be self-directed.  In fact, there are seven different types of accounts which can be self-directed.  They are the 1) Roth IRA, 2) the Traditional IRA, 3) the SEP IRA, 4) the SIMPLE IRA, 5) the Individual 401(k), including the Roth 401(k), 6) the Coverdell Education Savings Account (ESA, formerly known as the Education IRA), and 7) the Health Savings Account (HSA).  Not only can all of these accounts invest in non-traditional investments as indicated in Myth #1, but they can be combined together to purchase a single investment.
Myth #3. I don’t qualify for a self-directed Roth or Traditional IRA because I am covered by a retirement plan at work or because I make too much money.

Truth:

Almost anyone can have a self-directed account of some type.  Although there are income limits for contributing to a Roth IRA (in 2008 the income limits are $169,000 for a married couple filing jointly and $116,000 for a single person or head of household), having a plan at work does not affect your ability to contribute to a Roth IRA, and there is no age limit either.  With a Traditional IRA, you or your spouse having a retirement plan at work does affect the deductibility of your contribution, but anyone with earned income who is under age 70 1/2 can contribute to a Traditional IRA.  There are no upper income limits for contributing to a Traditional IRA.  Also, a Traditional IRA can receive funds from a prior employer’s 401(k) or other qualified plan.  Additionally, you may be able to contribute to a Coverdell ESA for your children or grandchildren, nieces, nephews or even my children, if you are so inclined.  If you have the right type of health insurance, called a High Deductible Health Plan, you can contribute to an HSA regardless of your income level.  With an HSA, you may deduct your contributions to the account and qualified distributions are tax free forever!  It’s the best of both worlds.  All of this is in addition to any retirement plan you have at your job or for your self-employed business.

Myth #4. I can’t have a self-directed 401(k) plan for my business because I am self-employed and file a Schedule C for my income.

Truth:

You can have a self-directed SEP IRA, a SIMPLE IRA or a 401(k) plan even if you are self-employed and file your income on Schedule C of your personal tax return.  With a SEP IRA, you can contribute up to 20% of your net earnings from self-employment (calculated by deducting one-half of your self-employment tax from your net profits as shown on Schedule C) or 25% of your wages from an employer, up to a maximum of $46,000 for 2008.  With the SIMPLE IRA, you can defer up to the first $10,500 of your net earnings from self-employment (calculated by multiplying your net Schedule C income by 0.9235% for SIMPLE IRA purposes), plus an additional $2,500 of your net earnings if you are age 50 by the end of the year, plus you can contribute an additional 3% of your net earnings as an employer contribution.  Beginning in 2002 even self-employed persons are entitled to have their own 401(k) plan.  Better yet, in 2006 the Roth 401(k) was added, allowing even high income earners to contribute after tax dollars into an account where qualified distributions are tax free forever!  With an Individual 401(k) you can defer up to $15,500 (for 2007 and 2008) of your net earnings from self-employment (calculated by deducting one-half of your self-employment tax from your net profits as shown on Schedule C), plus an additional $5,000 of your net earnings if you reach age 50 by the end of the year, plus you can contribute as much as an additional $30,500 based on up to 20% of your net earnings for 2008 (or 25% of your wages from an employer).  This means that a 50 plus year old self-employed person can contribute up to $51,000 for 2008!
Myth #5. Because I have a small IRA and can only contribute $5,000, it’s not worth having a self-directed IRA.

Truth:

Even small balance accounts can participate in non-traditional investing.  Small balance accounts can be co-invested with larger accounts owned by you or even other people.  For example, one recent hard money loan we funded had 10 different accounts participating.  The smallest account to participate was for only $1,827.00!  There are at least 4 ways you can participate in real estate investment even with a small IRA.  First, you can wholesale property.  You simply put the contract in the name of your IRA instead of your name.  The earnest money comes from the IRA.  When you assign the contract, the assignment fee goes back into your IRA.  If using a Roth IRA, this profit is tax-free forever! Second, you can purchase an option on real estate, which then can be either exercised, assigned to a third party, or canceled for a fee.  Third, you can purchase property in your IRA subject to existing financing or with a non-recourse loan from a bank, a hard money lender, a financial friend or a motivated seller.  Profits from debt-financed property in your IRA may incur unrelated business income tax (UBIT), however.  Finally, as mentioned above, your IRA can be a partner with other IRA or non-IRA investors.

Myth # 6. If I want to purchase non-traditional investments in an IRA, I must first establish an LLC which will be owned by my IRA.

Truth:

A very popular idea in the marketplace right now is that you can invest your IRA in an LLC where you (the IRA owner) are the manager of the LLC.  Effectively you have “checkbook control” of your IRA funds.  Providers generally charge thousands of dollars to set up these LLCs and sometimes mislead people into thinking that this is necessary to invest in real estate or other non-traditional investments.  This is simply not true.  Not only can an IRA hold title to real estate and other non-traditional investments directly with companies such as Quest IRA, Inc., but having “checkbook control” of your IRA funds through an LLC can lead to many traps for the unwary.  Far from protecting your IRA from the prohibited transaction rules, these setups may in fact lead to an inadvertent prohibited transaction, which may cause your IRA to be distributed to you, sometimes with substantial penalties.  This is not to say that there are not times when having your IRA make an investment through an LLC is a good idea, especially for asset protection purposes.  Nonetheless, you must educate yourself completely as to the rules before deciding on this route.  Having a “checkbook control” IRA owned LLC is kind of like skydiving without a parachute – it may be fun on the way down, but eventually you are likely to go SPLAT!
Myth #7. I can borrow money from my IRA to purchase a vacation home for myself.

Truth:

Although the Internal Revenue Code lists very few investment restrictions, certain transactions (as opposed to investments) are considered to be prohibited.  If your IRA enters into a prohibited transaction, there are severe consequences, so it is important to understand what constitutes a prohibited transaction.

Essentially, the prohibited transaction rules were made to discourage disqualified persons from dealing with the assets of the plan in a self-dealing manner, either directly or indirectly. The assets of a plan are to be invested in a manner which benefits the plan itself and not the IRA owner (other than as a beneficiary of the IRA) or any other disqualified person.  Investment transactions are supposed to be on an arms length basis.

As a result of these legal restrictions, a loan from your IRA or staying at a vacation home owned by your IRA, even if fair market rates are paid for interest or rent, would be prohibited.

Myth #8. With a self-directed IRA, I can borrow my IRA funds to purchase real estate and then put all the profits back into the IRA.

Truth:

When real estate or any other asset is purchased within a self-directed IRA, the money never leaves the IRA at all.  Instead, the IRA exchanges cash for the asset, in the same way that an IRA at a brokerage house exchanges cash for shares of stock or a mutual fund.  Therefore, the asset must be held in the name of the IRA.  For example, if Max N. Vestor were to purchase an investment house in his self-directed IRA, the title would be held as “Quest IRA, Inc. FBO Max N. Vestor IRA #12345-11.”  Since the IRA owns the asset, all expenses associated with the asset must be paid by the IRA and all profit resulting from that investment belongs to the IRA, including rents received and gains from the sale of the asset.

Myth #9. If my IRA buys real estate, it must pay all cash for the property.  An IRA cannot buy real estate with debt.

Truth:

An IRA can own debt-financed property, either directly or indirectly through a non-taxed entity such as an LLC or partnership.  Any debt must be non-recourse to the IRA and to any disqualified person.  An IRA may have to pay Unrelated Debt Financed Income Tax (UDFIT) on its profits from debt-financed property.  In general, taxes must be paid on profits from an IRA-owned property that is debt-financed, including profits from the sale or disposition of the property, in the same proportion that it had debt.  For a simplified example, if the IRA puts 50% down, then 50% of its profits above $1,000 will be taxable.  Although at first this sounds terrible, in fact leverage can be an extremely powerful tool in building your retirement wealth.  The same leverage principle applies inside or outside of your IRA – you can do more with debt-financing than you can without it.  One client was able to build her Roth IRA from $3,000 to over $33,000 in less than 4 months even after paying the taxes due by taking over a property subject to a debt and selling the property to another investor!

Myth #10. An IRA cannot own a business.

Truth:

A self-directed IRA is an amazingly flexible wealth building tool and can own almost anything, including a business.  However, due to the conflict of interest rules you cannot work for a business owned by your IRA and get paid.  Some companies have a plan to start a C corporation, adopt a 401(k) plan, roll an IRA into the 401(k) plan and purchase employer securities to effectively start a new business, but this is not a direct investment by the IRA in the business and is fairly expensive to set up.  Also, if your IRA owns an interest in a business, either directly or indirectly through a non-taxed entity such as an LLC or partnership, the IRA may owe Unrelated Business Income Tax (UBIT) on its profits from the business.  A solution to this problem may be to have the business owned by a C corporation or another taxable entity.