Foudation for Debate from the Advisor asking Quincy: Gentleman, The debate continues:) I actually have an account with Entrust out of Equity Trust in Ft. Myers, FL. I use this company website as a resource: http://www.trustetc.com/new/self-directed-ira/self-directed-investment-options/rehabs-and-flips.html 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.
IRA Investor 1: I find it very hard to believe that flipping notes could be considered appreciably different than transacting stocks quickly.
IRA Investor 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?
IRA Investor 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?
IRA Investor 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 ETC.
Advisor: 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: 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!
Advisor: Thank you for taking the time to help me out with this. It seems to me that it is best to 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: 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.