Self Directed IRA Services, Inc. » IRA Rules

Understanding Unrelated Debt Financed Income in an IRA

Kelli Click — Wed, 28 Dec 2011 21:48:57 +0000

Part 2: UDFI

In Part 1 of Understanding Unrelated Business Taxable Income, we discussed UBIT. The second type of UBTI that a self directed IRA may generate is Unrelated Debt Financed Income, or UDFI. UDFI may be generated when a tax exempt or tax deferred entity owns property that is debt financed. If an IRA holds leveraged real estate or an interest in an LP or LLC which obtained financing, the portion of the profit realized through the debt may be subject to UDFI tax, and taxed at trust rates.

UDFI Defined
Unrelated Debt Financed Income is covered in IRC 514, which defines debt financed property as “any property which is held to produce income and with respect to which there is acquisition indebtedness at any time during the taxable year.”

UDFI is only applied to profit realized through debt. An IRA may owe tax if income is generated by a leveraged property, or if debt financed property is sold for a profit. UDFI would not apply if the debt is paid off 12 months or more prior to the sale.

Calculating UDFI
Taxes are based on the highest amount of leverage the self directed IRA carried in the past 12 months. UDFI is only applied to the gain or profit realized through debt. The formula below is used to find the amount of income that is taxable as UDFI:

Average Acquisition Indebtedness is the average outstanding principal indebtedness during the portion of the year the property is held. This amount is found by averaging the amount of outstanding principal for the first day of each month that the property is held.

Average Adjusted Basis is found by averaging the adjusted basis of the property for the first and last day of the year that the property is held.

Gross Income from Property may be able to have certain deductions taken before calculating UDFI, such as depreciation. However, deductions for depreciation can only be taken by using the Straight Line Method; all deductions must be clearly related to the income and property.

When selling the investment at a profit, the taxable amount may be determined by dividing the Average Acquisition Indebtedness by the Average Adjusted Basis.

UDFI Tax Filing
If your IRA does owe UDFI, it is best to consult a tax professional for preparation of IRS Form 990-T. Once complete, Form 990-T can be submitted to the IRA custodian with the authorization to file and instruction to pay the UDFI tax.

Summary
Keep in mind that most self directed IRAs that hold leveraged real estate will not owe UDFI tax for the first few years due to depreciation.

If you are considering an investment that may generate UDFI, your tax advisor should be consulted in advance. To learn more about Unrelated Debt Financed Income please view IRS Publication 598.

Don’t Leave Your 401k Behind

Kelli Click — Wed, 28 Dec 2011 20:09:49 +0000

Rollover to an IRA and Expand Your Investment Options

As the stock market rollercoaster leaves much out of our individual control, there is something you may want to consider for gaining better control and protecting your retirement dollars from market losses.

A self directed IRA is a retirement tool that has allowed individuals to direct their retirement dollars into alternative investments, outside of the stock market, for over 35 years.

You can take control and rollover your 401(k) with a former employer into a self directed IRA. What advantages would it offer? Simply stated, a rollover provides the opportunity to diversify your retirement dollars in assets not available under the employer’s 401k plan.

The IRS doesn’t say what you can invest your IRA in, only what you cannot invest in (see IRS Pub 590). Specifically, section 408 of the Internal Revenue Code tells us we cannot invest our IRA dollars in life insurance contracts and collectibles (artwork, rugs, gems, stamps, etc.).

Beyond this, other investments are fair game as long as they are deemed to be made for “investment purposes only” (and not considered a prohibited transaction). For example, your IRA can not purchase a home for you (or those related to you) to live in. However, your IRA can purchase a property which you can lease to an unrelated party and have the rental income flow back into the IRA tax-free or tax-deferred.

In the chaos of changing jobs, people often forget about their 401k. The good news is that even after you leave an employer, you can still rollover your 401k to an IRA.

Do your homework and find the best investment for you. Your IRA can invest in alternative investments such as:
• Residential real estate, including apartments, single family homes, and duplexes
• Commercial real estate
• Undeveloped or raw land
• Real estate notes (mortgages and deeds of trusts)
• REITs (Real Estate Investment Trusts)
• Promissory notes
• Public or private limited partnerships and limited liability companies
• Private stock offerings
• Oil and gas investments
• Structured settlements
• Gold and silver bullion
• Publicly-traded stocks, bonds, mutual funds or ETFs (in a brokerage account)

Don’t leave your 401(k) behind with a former employer. Rollover to a self directed IRA and expand your investment options. Visit our website at www.SDIRAServices.com or contact us at info@SDIRAServices.com. Our toll-free number is (866) 928-9394.

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Understanding Unrelated Business Taxable Income (UBTI) in an IRA

Kelli Click — Tue, 27 Dec 2011 18:59:04 +0000

Part 1: UBTI

Making investments with funds from a self directed IRA provides a great tax advantage in that most income is tax free until distribution. However, there are certain situations in which a self directed IRA can generate taxable income in the form of Unrelated Business Taxable Income (UBTI) or Unrelated Debt-Financed Income (UDFI). UBTI is one of the more complicated areas of tax law, but the basic guidelines are fairly straightforward when it comes to UBTI generated by an investment held within an IRA.

UBTI Defined
According to IRS Publication 598, UBTI is “gross income derived by an organization from any unrelated trade or business regularly carried on by the exempt organization, less the deductions directly connected with carrying on the trade or business.” UBIT, or unrelated business taxable income is the tax that is paid on UBTI generated from a trade or business.

Publication 598 also states: “If an exempt organization regularly carries on a trade or business not substantially related to its exempt purpose, except that it provides funds to carry out that purpose, the organization is subject to tax on its income from that unrelated trade or business.”

There are exceptions, and most income generated by passive investments is exempt from paying UBIT, including income from dividends, annuities, royalties, interest from loans, and most rent generated from real estate.

Investments Generating UBTI
Investments most likely to generate UBTI include limited liability companies, limited partnerships, leveraged properties, and investments in active businesses.

In order for income to be subject to tax as UBTI the following must be true:
• The income is generated by a trade or business
• The trade or business activity is regularly carried on.
• The trade or business activity is not substantially related to the exempt status.

UBIT Tax Filing
At the end of the tax year investment sponsors will prepare and send out Schedule K-1. UBTI for the investment is shown under Section 20, Other Information. The amount of UBTI generated for the tax year is listed as Code V. If this figure exceeds $1,000, IRS Form 990-T would need to be filed to report and pay any UBIT due. Those required to complete Form 990-T will need to file for an Employer Identification Number (EIN), and can do so using Form SS-4

If your IRA does owe UBIT, it is best to consult a tax professional. A tax professional will ensure the registration and Tax Identification Number on the Schedule K-1 are correct, and prepare Form 990-T to submit to your IRA custodian. Once completed, you can then provide the Form 990-T to your IRA custodian with your authorization to file the form and pay the UBIT from your IRA account.

If you are considering an investment that may generate UBTI, your tax advisor should be consulted in advance. To learn more about Unrelated Business Taxable Income please view IRS Publication 598. This publication also covers Unrelated Debt Financed Income, which will be discussed in a later post.

Considering Real Estate in a Self Directed IRA?

Kelli Click — Tue, 27 Dec 2011 18:11:16 +0000

With the economic downtown, savvy investors are looking for investment opportunities in real estate and may consider using a self directed IRA or real estate IRA. After all, real estate has long been considered the number one way to building wealth – and what better way than to build wealth tax-deferred or tax-free than in a retirement portfolio?

Here are the basics to help you get started and understand how it works.

Find an IRA Custodian
Locate an IRA custodian, preferably a bank or trust company, which accepts real estate in a self directed IRA or real estate IRA. It’s best to use a custodian rather than an administrator. Administrators use the services of a third party to custody your IRA investments which creates an extra layer that can lead to problems. Custodians are regulated by a state or federal authority, while administrators are not subject to any regulatory oversight.

Likewise, if you use a facilitator or middleman to assist you in finding a property, make sure they either work with or recommend an IRA custodian. Many new firms offering self directed IRAs and real estate IRAs have entered the market in recent years promoting the LLC-structured concept of “checkbook control” IRAs. Under this scenario, the IRA owner has full control over the use of their IRA funds– something that seems to contradict the IRS rules and many IRA custodians consider a gray area. Even some regulators have recently become concerned with the checkbook control concept and fear it may mislead an investor into a prohibited transaction which could lead to disqualification of the IRA and result in taxes and possible penalties.

Funding the Purchase
Once you find the property you want to purchase, you can either use cash from your IRA to purchase the property outright, or you can locate a lender to finance the purchase. If your purchase will be financed, the lender must use a non-recourse promissory note. This limits the recourse the lender would have to only the underlying property (and not other IRA assets) in the event of default. No other IRA assets or personal assets can be used to collateralize the loan. If your IRA purchase uses debt financing, you should be aware that this would generate Unrelated Business Taxable Income (UBTI) and discuss this with your tax professional.

Starting the Transaction
It is also important to remember that the purchase offer and contract must identify the named purchaser as your IRA custodian for benefit of your IRA account (i.e., Self Directed IRA Services, Inc., Custodian FBO John Doe IRA). In addition, all funds, including the earnest or escrow deposit must be paid directly from the IRA rather than out of your personal pocketbook. Also, a closing date should not be set until the IRA is established and funded with your custodian.

Spare Funds Needed
Keep in mind that all expenses related to owning, maintaining or improving the property owned within an IRA must be paid by the IRA. This includes maintenance, repairs, taxes, insurance and improvements, as well as any mortgage payments if debt-financed. The way this usually works is that once you receive a bill or invoice for the expense, you would sign it as approved and send it, along with payment instructions, to your IRA custodian. The custodian then issues the payment from your IRA.

Income-Producing Property
If the property generates any income through rental or lease of the property, the income must flow back into the IRA. So whether you have residential, commercial, raw land or vacation renters, any tenant of the property would need to write checks to the IRA rather than to you personally. With an income-producing property, you may be required to use a third party property manager to handle the process and remit the income to your IRA. Your custodian will provide the specifics for how this should work.

Keep it Arms-Length
Now, let’s address the questions we hear most often—
• Can I use the property for a vacation home?
• Can I lease the property to my son/daughter to use for their business?
• Can my IRA buy a property that I/my parents currently own?

These questions fall under the rules about prohibited transactions and self dealing under Internal Revenue Code § 4975. A prohibited transaction most commonly results when your IRA engages in a transaction with a disqualified person, primarily:

• The IRA owner and their spouse,
• The IRA owner’s ancestors (parents and grandparents) or lineal descendants (children and grandchildren) and their spouses,
• Any entity in which the IRA owner has a combined ownership of 50% or more.

In general, you cannot have any direct use or benefit of the property owned within your IRA. Likewise, you should not engage in a transaction with a family member. This means your IRA cannot lease a property to a disqualified person, nor can it buy or sell a property from a disqualified person. As a general rule, if you follow the guidelines set forth, your IRA transaction should be okay.

Selling the Property
The property can be sold at any time to an unrelated party and the proceeds from selling an IRA-owned property roll back into the IRA without facing capital-gains taxes.

You can then invest the proceeds in another property or any other asset within your IRA. When you eventually withdraw funds from the IRA, the profit would be taxed at ordinary income rates when withdrawn from a traditional IRA— or tax-free if in a Roth IRA.

Summary
Given the uncertainty in today’s mainstream investments, real estate is gaining a great deal of interest as an investment option in self directed IRAs. It’s easy to see why. After all, most people prefer to invest in what they know and understand.

Knowing the rules associated with owning property in your IRA is essential, so do your homework and consult with your tax advisor so they may cover the details relating to the investment you are considering.

Whether your retirement strategy is to retain properties or buy and sell for gain, real estate investing through your IRA can yield astonishing profits toward your potential retirement.

Learn About the 2010 Roth IRA Conversion Rules

Kelli Click — Tue, 27 Dec 2011 17:54:43 +0000

The year 2010 opens the door for many individuals to consider converting from a Traditional IRA to a Roth IRA. On January 1, the new Roth conversion rules became effective. You have probably heard of this opportunity by now, and may have some questions about the new rules and implications. While the decision of whether or not to convert your IRA is one you should make with your tax advisor, we would like to share the answers to most commonly asked questions about the new Roth IRA conversion opportunity.

What is the 2010 Roth IRA Conversion opportunity?<br />
For the first time since the Roth IRA debuted in 1998, individuals with an Adjusted Gross Income (AGI) over $100,000 can convert all or part of their Traditional IRA into a Roth IRA. This means that higher wage earners now have the opportunity to convert their current tax-deferred retirement dollars to tax-free status upon retirement. The conversion may be a good option for those who think they’ll be in a higher tax bracket when they withdraw, don’t see themselves withdrawing funds for at least 10 years, and can pay the taxes due from sources other than the IRA.

When do I pay taxes on the conversion?<br />
You have the option to pay the tax in full in 2010 or to claim 50% of the conversion amount in 2011 and the remaining 50% in 2012 – but keep in mind that this special provision is only for those that convert in 2010. For conversions after 2010, taxes would be paid in full for the year in which the IRA is converted. If you decide to convert in 2010 and opt to split the taxes in 2011 and 2012, there are a couple of things you may want to keep in mind— the tax rate you pay would be determined based on your tax bracket for 2011 and 2012, and the current tax cuts are set to expire at the end of 2010.

Can I still contribute after the conversion?<br />
That’s the part that did not change. The phase out limits still apply when determining whether an individual is eligible to contribute to a Roth IRA for 2010. Individuals may make a partial or full contribution (up to $5,000; $6,000 for individuals age 50 and over) to a Roth IRA as long as their AGI falls below or within the phase out range. For single filers in 2010, the phase out limit is $105,000-120,000. For those filing jointly in 2010, the phase out limit is $166,000-176,000. Individuals above the limit are not eligible to make Roth IRA contributions.

What if I convert and later decide it wasn’t right for me?
Those who convert and then later change their mind can do a recharacterization. This allows the IRA owner to reverse the conversion completely and can be done until October 15th of the calendar year after the year the conversion took place. So, if you decide to convert in 2010 you would have until October 15, 2011, to recharacterize. IRA account holders are not allowed to reconvert back to a Roth IRA within the same tax year or within 30 days of a recharacterization.

Converting to a Roth IRA can get tricky, especially if you have multiple IRAs or only want to do a partial conversion. That’s why it’s important to discuss this with a tax professional to make sure you fully understand what the tax implications would be for your specific situation.

Understanding Prohibited Transactions and How to Avoid Them

sdiraservices.com — Tue, 23 Feb 2010 21:08:16 +0000

A self directed IRA can open the door to many investments that you may have not considered. A short list of investments your IRA may not invest in is spelled out in IRC section 408 including S-corp stock, life insurance contracts and collectibles such as artwork, rugs, antiques, etc. Discovering such a large magnitude of investment options can generate a lot of excitement. It’s important when exploring possible options for your self directed IRA that you understand the rules surrounding the investments so that your IRA does not do business with any disqualified member or engage in any prohibited transactions. These rules are discussed in IRS Publication 590 and Internal Revenue Code 4975.

The IRS does not indicate what investments and transactions are allowable with IRA funds; instead they identify those that are prohibited. A Prohibited Transaction can bring into question the tax-deferred status of your IRA, potentially resulting in the disqualification of your account and substantial tax consequences. If it is determined that a Prohibited Transaction has occurred your IRA would be treated as a distribution as of the first day of the year in which the Prohibited Transaction took place.

What is a Prohibited Transaction?

Prohibited Transactions usually occur when the IRA engages in transactions with a disqualified person.

Who would be considered Disqualified Person?

The IRA owner
The spouse of the IRA owner
Any lineal descendants and their spouses
Any lineal ascendants and their spouses
Investment advisors and managers
Anyone providing services to the IRA such as a trustee or custodian
Any entity in which any above person has a 50% or more interest

What Prohibited Transactions commonly occur?

Borrowing money from your IRA.
Selling property to your IRA.
Receiving unreasonable compensation for managing an IRA asset, such as a rental property.
Using your IRA as security for a loan.
Buying property for personal use (present or future) with your IRA funds.

These rules were put into place for the IRS to ensure that all of the business conducted with the IRA is for the benefit of the IRA. Because the funds are intended for future retirement, actions that create an indirect benefit for the IRA owner could disqualify the IRA. Common examples of indirect benefits include:

Indirectly tapping funds for personal use

If two or more IRA owners loaned each other funds to avoid a Prohibited Transaction it would be considered an indirect benefit. The parties may not be on the disqualified persons list, but if a party indirectly benefits from the transaction, this action could potentially disqualify the IRA.

Sweat equity

If your IRA holds a property that needs improvements, providing the labor or having another disqualified person or their company provide the labor would be a prohibited transaction. You would also not be able to use any personal tools or equipment to improve a property held by the IRA.

It may seem like there a lot of rules to remember on what you cannot do with your IRA. But keeping your IRA from engaging in Prohibited Transactions is the best way to protect your interest in your retirement. You can easily avoid Prohibited Transactions by following these three simple rules when contemplating a transaction in your IRA.

First, make sure that anyone your IRA will be doing business list is not a disqualified person.

Second, avoid investing in collectibles, S-corp stock or life insurance contracts.

Third, look closely at the potential transaction with your tax advisor to decide if it would result in an indirect benefit to you or any other disqualified person.

Following these steps can help steer you away from potential prohibited transactions while still leaving the door open for numerous investments.

More information on self directed IRA investment options and prohibited transactions can be found in our IRA Resource Center.