Category: Additional Articles

Most people understand that an IRA is normally not a taxable trust and its income is not taxed until the income is distributed (or not at all, if it is a qualifying distribution from a Roth IRA). However, there are 2 circumstances when an IRA may owe tax on its income. First, if the IRA is engaged in an unrelated trade or business, either directly or indirectly through a non-taxable entity such as an LLC or a limited partnership, the IRA will owe tax on its share of Unrelated Business Income (UBI). Second. if the IRA owns, either directly or indirectly, property subject to debt, it will owe tax only on the portion of its income derived from the debt, which is sometimes referred to as Unrelated Debt Financed Income (UDFI).

I will refer to either tax as Unrelated Business Income Tax (UBIT) in this article.
From a financial planning perspective, the question becomes “Should I avoid doing something in my IRA which may incur UBIT?” Many people just say “Forget it!” when they learn a certain investment may subject the IRA to UBIT. Or worse yet, they ignore the issue and hope they won’t get caught. However, being afraid of UBIT is short sighted and ignores the opportunity it presents for building massive wealth in your retirement plan. Remember, making an investment which may subject the IRA to UBIT is not a prohibited transaction, it just means the IRA has to pay a tax. The best financial advice on UBIT is simple: “Don’t mess with the IRS!” If the IRA owes UBIT, make sure it is paid.
“But,” you object, “doesn’t this mean I am paying double taxation?” Unless your IRA is a Roth IRA, it is true that in these 2 circumstances the tax will be paid by the IRA and again by the IRA holder when the income is distributed. However, in my view this is the incorrect focus. Is the IRA glass 1/3 empty or 2/3 full? At least the IRS is a silent partner. The double taxation issue is no different when investing in stocks traded on the stock exchange, since corporations pay tax on income before issuing dividends to shareholders, and the value of the stock takes into account that the company must pay income taxes.
Two key questions arise when analyzing a “UBIT investment.” The first question to ask in UBIT analysis is “What tax would I pay if I did the same transaction outside of my IRA?” The only “penalty” is the amount of tax the IRA would pay above the amount that you would pay individually. If you make the investment personally, you not only will pay tax on the income from the investment, but also from the next investment, and the next one after that. At least within the IRA you have the choice of making investments with your proceeds which do not incur UBIT. A second question to ask is this: “Will my after UBIT return exceed what I could make on other IRA investments?” Why should you turn away from an investment in your IRA which will give you an incredible return even after paying the tax?
Let me give you one powerful example of how paying UBIT might make a lot of sense. One Quest client purchased a property in her Roth IRA subject to approximately $97,000 in delinquent taxes (this is the same as a mortgage for UBIT purposes). The owner was willing to walk away from the property for $75 just to get rid of the headache and the lawsuit pending against him by the taxing authorities. With closing costs the IRA spent around $3,000 to acquire the property. Only 4 months later the property was sold to another investor, and the Roth IRA netted around $46,500 from the sale after paying delinquent taxes and sales expenses. Because the IRA purchased the property subject to debt (the delinquent taxes), it owed UBIT in the amount of approximately $13,500 on its short term capital gain. This meant that even after paying UBIT the IRA went from $3,000 to approximately $33,000. That is a return of over 1,000% in under 4 months, or an annualized return of over 4,000%! This client will obviously have an easier time making money with her $33,000 Roth IRA than she could have with her $3,000 IRA. Since this was a Roth IRA, no more tax will be owed on this income if it is distributed as a qualified distribution after age 59 ½ or from any other income generated in this IRA from investments that are not subject to UBIT.

Ignorance of the tax law is no excuse. You can find out more on this topic by reviewing IRS Publication 598, or by visiting with your tax advisor. After analyzing a transaction, you may come to the conclusion that paying UBIT now in your IRA may be the way to financial freedom in your retirement. Like I often say, “UBIT? You bet!” The information contained in this article is not intended to be tax or investment advice.

Many people find it very easy to see the benefits of self-directing their Roth and Traditional IRAs, SEP IRAs, SIMPLE IRAs, Individual 401(k)s, Coverdell Education Savings Accounts (ESAs) and Health Savings Accounts (HSAs) into something other than the same old boring stocks, bonds, annuities and mutual funds. The central idea of a self-directed IRA is that it gives you total control of your retirement assets. With a self-directed account you can invest your IRA funds in whatever you know best.
When I spoke recently at John Schaub’s Real Estate All Stars conference in Las Vegas, Nevada, I outlined some of the top strategies our clients have actually used to build their retirement wealth. A brief description of these strategies is included in this article. This shows the tremendous flexibility of investing through a self-directed account.

 
Strategy #1 – Purchasing Rental Real Estate for Cash. Even the IRS acknowledges on its website that real estate is an acceptable investment for an IRA. In answering the question “Are there any restrictions on the things I can invest my IRA in?” the IRS includes in its response that “IRA law does not prohibit investing in real estate but trustees are not required to offer real estate as an option.” One of our clients purchased a 10 unit apartment complex for $330,000 cash. In April, 2008 his total rent collection was $5,235. Even after payment of taxes and insurance, his cash on cash return is excellent, and the client believes that the value of the property will increase significantly over time. A discussion of the relative benefits and disadvantages of owning real estate directly in an IRA is beyond the scope of this article, but for those who know how to successfully invest in real estate it is great to know that real estate is an option for your self-directed account.
Strategy #2 – Purchase, Rehab and Resale of Real Estate. In this case study, our client decided not to hold onto the real estate purchased with his IRA. The client received a phone call one evening from an elderly gentleman who said he needed to sell his home quickly because he wanted to move to Dallas with his son. After a quick phone conversation, it was clear that the price the seller wanted was a bargain even considering the needed repairs. Our client dropped what he was doing and immediately headed over to the seller’s house with a contract. The buyer on the contract was our client’s IRA, and of course the earnest money came from the IRA after the client read and approved the contract and submitted it with a buy direction letter to Quest Trust Company. They agreed on a sales price of $101,000. Approximately $30,000 was spent rehabbing the property with all funds coming from the IRA. The property was sold 6 months later for $239,000, with a net profit after sales and holding expenses of $94,000!
Strategy #3 – Purchase and Immediate Resale of Real Estate (Flipping). The previous two examples show the tremendous power of buying real estate for cash with a self-directed IRA. However, both of these strategies require a significant amount of cash in your account. How else can you invest in real estate if you have little cash? One of our clients was able to put a commercial piece of vacant land under contract in his Roth IRA. The sales price was $503,553.60 after acreage adjustments. Using his knowledge of what was attractive for a building site, our client was able to negotiate a sales price to a major home improvement store chain for $650,000. On the day of closing Quest received two sets of documents, one for the purchase of the property for $503,553.60 and the other for the sale of the same property for $650,000. After sales expenses, the IRA netted $146,281.40 from the sale with only the earnest money coming from the account! A word of caution in this case is that if property is flipped inside of an IRA the IRS may consider this to be Unrelated Business Taxable Income (UBTI), causing the IRA (not the IRA owner) to owe some taxes on the gain. Even if taxes had to be paid, it is hard to argue that this transaction was not beneficial to the IRA and ultimately the client! It should also be noted that in this situation everyone involved in the transaction was aware of what everyone else was doing, so there was no “under the table” dealings.

Strategy #4 – Assignments and Options – Getting Paid NOT to Buy! Another favorite strategy for building tremendous wealth without a significant amount of cash is the use of options and assignments. One of our clients put a property under contract in his daughter’s Coverdell Education Savings Account for $100. The sales price was a total of $5,500 because the house had burned down. The seller was just getting rid of the property for its lot value since he had already received a settlement from the insurance company and had purchased another house. Our client then used his contacts to find a person who specialized in rehabbing burned out houses. The new buyer was willing to purchase the property for $14,000 cash. At closing one month after the contract was signed, the seller received his $5,500 and the Coverdell ESA received an assignment fee of $8,500 right on the settlement statement. That is an astounding 8,400% return on the $100 investment in only 30 days! Even better, our client was then able to take a TAX FREE distribution from the account of $3,300 to pay for his 10 year old daughter’s private school tuition. In a similar transaction, another client’s Roth IRA recently received an assignment fee of $21,000 plus reimbursement of earnest money for a contract.
Strategy #5 – Using the Power of Debt Leveraging. One of my favorite true stories of building wealth in a Roth IRA involves purchasing property subject to a debt. If an IRA owns debt-financed property either directly or indirectly through a non-taxed entity such as a partnership or LLC taxed as a partnership, profits from that investment are taxable to the same extent there is debt on the property. One of our clients used her knowledge of real estate investing and what she learned from a free Quest educational seminar to tremendously boost her retirement savings. After noticing a large house in downtown Houston which was in bad shape but in a great location, our client tracked down the owner in California who was being sued for approximately $97,000 in delinquent taxes on the property. She negotiated a deal with the seller for her Roth IRA to purchase the property for $75 cash subject to the delinquent taxes. With closing costs her Roth IRA’s total cash in the transaction was only around $3,000. Within 4 months she was able to sell the property for a profit to her Roth IRA of $43,500! Because the property had debt on it and because her Roth IRA sold the property for a short term capital gain, the taxes on the profit were approximately $13,500. Still, using the power of debt leveraging her Roth IRA was able to achieve a 1,000% return in less than 4 months even after paying Uncle Sam his share of the profits!

Strategy #6 – Hard Money Lending. Another excellent strategy for building your retirement wealth is through lending. Loans from IRAs can be made secured by real estate, mobile homes or anything else. Some people even choose to loan money from their IRAs on an unsecured basis. As long as the borrower is not a disqualified person to the lending IRA, almost any terms agreed to by the parties are acceptable. In many states there are limits to the amount of interest that can be charged, and loans must be properly documented, but IRA law does not impose any limits other than the prohibited transaction rules. For those wanting to avoid the direct ownership of real estate within their IRA, a loan with an equity participation agreement is often used. Several of my own self-directed accounts combined together recently to make a $25,000, 7 1/2 year, 12% first lien loan against real estate with 6% in points up front. True, this is not exactly setting the world on fire as far as return on investment goes, but I was very pleased with a safe return on a relatively small amount of cash. If I get to foreclose on the collateral my accounts should be able to make a substantial profit, since the land securing the loan was appraised at $45,000. At my office we routinely see hard money loans secured by first liens against real estate with interest at 12%-18% for terms ranging from 3 months to 3 years.
Strategy #7 – Private Placements. Many of the best opportunities for passive growth of IRAs include the purchase of private limited partnership shares, LLC membership units and private stock which does not trade on the stock market. Let me give you two examples from my own retirement account investments. In one case my 401(k) plan invested in a limited partnership which purchased a shopping center in northern Louisiana. The initial investment was $50,000, and in a little over 2 years the partnership has returned $59,321. The plan’s remaining equity is estimated as of 12/31/2007 at $31,598 and the return on investment will be around 82%. Even though the property is debt-financed the taxes on the profit have been almost nothing since the plan has taken advantage of depreciation and all of the normal deductions. Once your IRA or other plan owes taxes due to debt financing, it gets to deduct a pro rata share of all normal expenses. Another of my 401(k) plan investments is bank stock of a community bank in Houston, Texas. The initial shares were sold at $10 per share in February, 2007. The book value after less than 1 year of operations was $11 per share, and shares have recently been selling to other private investors for as much as $14.25 per share! That is a great return for a completely passive investment, and when the bank finally sells the shares are expected to sell for well above these amounts.

Strategy #8 – Owning a Business in Your IRA. One of the most innovative strategies we have seen is the ownership of a business by an IRA. Although neither you nor any other disqualified person may provide services to or get paid for working at a business owned by your IRA or other self-directed account, this does not mean that your IRA cannot own a business. Some companies do market the ability for you to start a C corporation, adopt a 401(k) plan, roll your IRA into the plan, and purchase “qualifying employer securities,” but this is different than an IRA owning a business directly. For example, my Health Savings Account invested $500 for 100% of the shares of a corporation which arranges for hard money loans to investors. The company is fully licensed as a Texas mortgage broker. The structure of the company is a C corporation. Since being a mortgage broker is a business operation, profits from the venture would have been taxable to my HSA if the entity formed to own the business was not taxable itself, and the tax rates for trusts such as IRAs and HSAs are much higher than for corporations. While normally dividends from C corporations are taxable a second time to the shareholder, dividends paid to an IRA or HSA are tax free as investment income. The corporation is run by non-disqualified persons who handle the due diligence on the loans and the legal work, as well as by a licensed Texas mortgage broker who sponsors the corporation’s mortgage broker license.

Strategy #9 – Using OPI (Other People’s IRAs) to Make Money Now. Even if you have not found the investment strategy of your dreams among the strategies discussed in this article, or if you have no IRA or if you are more focused on making money now to live on, your time spent reading this article can still be of great use to you. For each of the above strategies I have focused on the possibility that your IRA could be the investor. But what if you are the recipient of the IRA’s investment money? Are you a real estate investor having a hard time finding funding for your transactions? If you know people with self-directed IRAs or people who would move their money to a self-directed account, you can borrow their IRA money and virtually create your own private bank! You can also partner with OPI where the IRA puts up the money and you share in the equity for finding the deal and managing the project. Simply by explaining to people that they can own real estate in their IRAs you may be able to sell more property, either as a real estate broker or as the seller. You can even provide financing for your sales by having OPI make loans to your buyers. Finally, OPI can be a great way to raise capital for your business venture, although you must be aware of and comply with all securities laws. One bank I know of told me that 42% of their initial capital came from retirement accounts! Although you cannot use your own retirement account to benefit yourself at present unless you are over age 59 1/2, these are just some of the ways you can use OPI to make money for yourself right now. A good network is the key to your success.
What I have discussed in this article have been some of the more common investment strategies actually used by our clients. The only restrictions contained in the Internal Revenue Code are that IRAs cannot invest in life insurance contracts or collectibles. Almost any other investment that can be documented can be held in a self-directed IRA. As long as you follow the rules and do not invest in prohibited investments, your only real limitation is your imagination!