Self Directed IRA Services, Inc. » IRC 4975

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.

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.

Debt-Financed Property with your IRA

Kelli Click — Tue, 27 Dec 2011 18:31:26 +0000

Real estate is a popular self directed IRA investment, and we previously covered a few of the basics of owning real estate in an IRA. There are times when investors are interested in a particular residential or commercial property but only have a portion of the funds needed for the purchase available. Self directed IRA owners that find themselves in this position may have the option to finance the purchase with a non-recourse loan from an IRA lender.

A non-recourse loan is one in which the lender has no recourse to other assets owned by an IRA owner in the event of default. If the loan goes into default the lender may take possession of the underlying property, but it would be the only eligible asset that the lender would be able to pursue.

Few companies offer IRA lending, and the requirements for a loan to an IRA are very different than for personal loans. Here are a few points to consider if you are thinking about financing a property with your IRA:

1) A minimum of 30% down is needed, with some lenders requiring 40%.
2) The property appraisal and potential income will be the main points of consideration.
3) Properties that are not move-in ready or needing only minor work or repairs may not qualify for funding by the lender.
4) Most IRA lenders will require that a portion of the loan remain in the IRA account for any expenses that might come up.
5) The IRA may need to pay unrelated business income tax (UBIT) on the leveraged portion of the real estate.

Self Directed IRA Services, Inc. does not recommend any individual investments, and as a self directed IRA custodian, we do not offer non-recourse loans. For more information on non-recourse loans in a self directed IRA you may view the FAQ and Fact Sheet provided by Matt Allen, Director of IRA Lending, at www.IRALending.com.

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.

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.