Colorado Real Estate Journal - December 16, 2015
M any real estate investors have heard about the benefits of using self-directed individual retirement accounts to fund their latest ventures into the real estate market. There are many companies conducting seminars and webinars that sell the investor on this idea. I know firsthand because our office receives the very same marketing material. While the current state of the law does seem to allow for these transactions, unfortunately many investors are not aware of the limitations that the tax code imposes on these types of transactions. In this article I’ll explore two considerations every investor should be aware of before using a self-directed IRA to invest in real estate: 1) prohibited transactions and 2) unrelated business income tax. The danger of prohibited transactions. To begin, I’d like to share a quick word about the danger and what’s at stake. The tax code (specifically 26 USC § 4975) is written in such a way that there are numerous “prohibited transactions” in which an IRA is simply not allowed to engage. If an IRA moves forward with one of these transactions, the ramifications are enormous. If you believe you may be in danger of running afoul of these rules (or maybe you think you’ve already broken a rule), then speak to your tax adviser as quickly as possible to explore your options and the full extent of the penalties that you may face. There are strategies to minimize the impact, but it is critical to be proactive and correct the transaction quickly! I won’t explore all of the ramifications here just to keep things fairly simple, but the heart of what the law does is that it causes an investor’s IRA to lose its IRA status. In other words, the IRA simply ceases to be an IRA on the first day of the taxable year in which the transaction takes place. The IRA is treated as having distributed all of its assets to the investor and there’s the potential that the investor will be hit with a large tax bill as a result. Finally, penalties will likely apply, further reducing the investor’s retirement funds. Transactions to avoid. So what transactions, exactly, are we talking about? The law is written in general terms to cast a wide net. If you are thinking of entering into a transaction and aren’t sure if you should, I cannot stress enough the importance of consulting with your tax adviser. The law is generally written to avoid self-dealing between a “disqualified person” and the IRA. A disqualified person includes, among others, the fiduciary in charge of the plan, any individual providing services to the plan, an employer whose employees participate in the plan, the person for whom the IRA is established or a member of that person’s family (spouse, ancestor, lineal descendant or spouse of a lineal descendant). Specific examples of prohibited transactions will include: •Use of IRA income or assets for a disqualified person’s own benefit; •Leveraging or using IRA assets as security for a loan (nonrecourse loans are allowed); •The following actions between the IRA and a disqualified person: ° Selling, exchanging or leasing property; ° Lending money or extending credit; ° Furnishings, goods, services or facilities; ° The outright transfer of IRA income or assets to the disqualified person. Unrelated business income tax. IRAs are unique and they benefit greatly from their preferential tax treatment. Interest groups were concerned that an IRA conducting business activities would have an unfair advantage and regular businesses would not be able to compete. Because of this concern, Congress drafted a special tax into the tax code called Unrelated Business Income Tax. Unrelated business income is simply income derived from a trade or business that is regularly carried on and is not substantially related to the tax-exempt purpose of the IRA. In the real estate context, a very common example of IRA transactions that generate UBIT is leveraging a rental property with a nonrecourse loan. When this occurs, a portion of the income received in rents (and possibly on the sale of the property) is subject to UBIT. UBIT, however, is not the end of the world and a little context is necessary here. First, if your IRA is subject to UBIT, that really means that your investment is paying off. In other words, the investment in your IRA is generating profit and that means that your retirement account is growing. Next, the IRA will simply prepare and file a tax return (Form 990-T) and pay any tax that may be due. UBIT is not nearly as important of a concern as the prohibited transaction because it doesn’t carry the same consequences, but in my practice I’ve found that not many investors who are considering the use of the IRA to invest in real estate are even aware of the tax. Wrapping it up. To bring this to a close, as a tax professional I have met with many established and new clients who would like to take advantage of the funds in their IRA to begin tapping the real estate market and grow their retirement nest egg. I understand the temptation, especially here in Denver. Time and again, I advise my clients of the important limitations found in the tax code and ensure that they do not run afoul of any of these arguably lesser known corners of the regulatory framework surrounding IRAs. If you are a real estate investor, my final bit of advice is to choose your advisers carefully and ensure that you surround yourself with a knowledgeable team that can advise you concerning the many aspects of a particular investing strategy. Doing so will help ensure your continued success in this rewarding and fast-paced market.