How to Streamline Private Loans in your SDIRA with Quest Supervisor Robyn Ruston

Thank you for joining me today. I have Quest’s Dallas Office Supervisor and transaction specialist Robyn Ruston here with me today. She’s an expert when it comes to almost anything involving real estate, notes, or private entity purchases. Today, we are going to be talking about how to streamline the process for lending and borrowing when a Self-Directed IRA is involved. 

Sarah: If someone is interested in doing a private loan with their Self-Directed IRA, what does one even need? Whether that be making sure preliminary boxes are checked or providing forms, what is needed to make sure that funding gets taken care of? 

Robyn: Well, first and foremost, the IRA accounts have to have funds. Then, it depends on what type of note they want to do. So, they decide that with the borrower, what kind of note they want to do, (secured or unsecured). For instance, we’re always going to have to have a Direction of Investment Form. It doesn’t matter what kind of loan they’re going to do, they will always need the Direction of Investment. It’s our internal form that tells us, you know, where to send the money, their interest rate, maturity date. It just gives us the general information of what the investment is. It tells us the pertinent information on how to process the funds. 

Sarah: And that information is very important. We can’t fund without it.  

Robyn: Right. So, if they want to do one that is secured with a note, then we would need a promissory note and we need the deed of trust and/or mortgage showing that the IRA is the lender. Once the note is completely paid off, the borrower will submit a release of lien and Quest will sign it releasing the IRA from that asset.  The supporting documents specify the terms between the borrower and the lender. The biggest thing to remember is that, in order for them to do any type of investment, we always need supporting documents determining whatever they’re going to do. 

Sarah: Got it. I also heard you mention… you touched on the fact that they have to decide all those terms. That’s an important part there.  

Robyn: Yes, that’s decided between the borrower and the lender. They decide all the terms, and how it’s going to be written. They find somebody who drafts all the documents surrounding the investment. That’s what makes it self-directed. As the custodian, we review all documents and we make sure that it’s in compliance with IRA terms. We make sure that we have the right vesting on there, and that we have the information that’s needed in order for us to be able to hold that investment. 

Sarah: Perfect. So, I’m sure that you probably have lenders calling in all the time asking “how do I fill out these forms?”, and “What do I do?”. How often do you get lenders and borrowers calling in for questions and how do you address those?

Robyn:  When it comes to answering questions, we can answer questions for the borrower and to the lenders. But we can only answer questions for the borrower to an extent, as long as they don’t pertain to the lenders account. We don’t mind like talking to the borrower to let them know what’s needed or the steps for the investment process, just so both sides of the party are fully aware of the steps that are required to make an investment happen. So, we do also talk to the borrowers often. 

Sarah: I’m sure one of the biggest questions that a lot of the borrowers have when they call in is “I have to pay back my lender! How do I do that?”. How does the lender get paid back? Can you talk a little bit about that and where those funds have to go? 

Robyn: There are a couple of different ways. We can always provide Delivery Instructions to our lenders, so that the borrowers can make payments a couple different ways. They can wire over the funds to an IRA account. They can send them via ACH or through check, and they can even use our online payment methods. You know, we make it pretty simple and easy. They will send the funds directly to Quest and then we will allocate those properly to the clients’ IRA accounts. 

Sarah: Now, one thing that you touched on there that’s really important – something that I think all of our readers should know – is those funds have to go back to the IRA accounts. I’m sure that’s a big mistake many people make. Interest payments must be made to the IRA. 

Robyn: Exactly

Sarah: So, while they’re going through that funding process, what’s one of the biggest things that you see holds people up getting that investment funded on time?

Robyn: Most of the time, you know, what I see is that the documents aren’t worded right; we don’t have the correct language, meaning the vesting is incorrect. Another is that we don’t have any wiring instructions. So, the best way to just kind of make that go quicker is to make sure the client understands a few things. We always let the client know, “why don’t you go ahead and get the terms drafted and then submit those over to us.” Let us look at them. We’ll tell them, “this needs to be corrected. That needs to be corrected.” Once you get the final draft, that’s when I would get people’s signatures and stuff like that, because every time you make a mistake or every time you have to correct the document, you have to go back and get a signature again. 

Sarah: I can see how that could be a holdup.

Robyn: The best way to streamline the process is to go ahead and just submit all documents over for a preliminary reviewWe can’t draft it, but we can review it and let you know if it meets all of our requirements. We can say, “go ahead and get the borrower to execute” or we can let them know, “hey, your vesting is incorrect or you’re missing the maturity date, basic information”. That way they can correct it.

Sarah: And even if one thing is missing, that’ll hold something up. We have got to have it all. 

Robyn: We’ve got to have it all. 

Sarah: One thing that you mentioned at the very beginning when we were talking about what’s needed, you said that it depends on what type of note and I want to go back to that, because that was really important. There are unsecured versus secured. Now, if somebody wants to do an unsecured note, what type of due diligence should be done before entering in to a Self-Directed IRA investment like that. 

Robyn: Yes, we recommend that the client does a bit of research and that they know what they are investing in, especially with an unsecured note. The great thing about our IRAs is that they are self-directed, but it can also put more responsibility on the account holder since all of the investment details are curated between the lender and the borrower. It’s best definitely to do some due diligence and just make sure that they are aware of what they’re investing in, making sure that they are agreeing to these terms in this loan, right? And then to just making sure that everyone’s goals is met at the end of their investment, their promissory note. 

Sarah: Mhm. Perfect. Moving right along… What are some common questions that you get? What do people call in and have the most questions about? Let’s address some of those. 

Robyn: [chuckles] Mostly, “where’s my funding?” Oftentimes, we get asked, “can we go ahead and fund without a signature from the borrower” or “how is the investment status, what is the status of the investment?” 

Sarah: And if they wanted to check on the status of an investment, do they have somewhere where they can do that? 

Robyn: Yes. The QTC Investment Hub has an investment tracker. It’s located in their Client Portal. 

Sarah: Awesome, well do you have any other words of advice that you would give to either lenders or borrowers to help them streamline the process?

Robyn: Yes. To just make sure that, as the client, they are responsible for knowing what is exactly needed for their note and what we look for. That way they know for when they’re getting their note drafted. We can always send it over to them through email. So, when they’re getting it drafted they can make sure that everything is included. I also recommend that, before they even start to process, do their digital research. Really look into who they’re borrowing from or on the other side, who they’re lending to. Go on the internet, Google at home, see if you can find out any information, and check with somebody who’s already invested with those people. You know, just kind of get their feedback on anything. Borrowers should be willing to let you talk to somebody who has already invested with them or lent them money. 

Sarah: That is such a good point. 

Robyn: If they have a good track record, they shouldn’t have any problem answering your questions. So, just pick it apart and just make sure that you know what you’re going into. And that last thing is just to set realistic expectations and times. All of this will really help in streamlining the process. 

Private loans and other notes continue to be one of the most popular investments held in Self-Directed IRAs, and it’s’ helpful to understand some of the ways to keep the process moving smoothly. If you have more questions about how to lend and borrow funds with a Self-Directed IRA, feel free to call our office at 281.492.3434 and a representative will be happy to help answer any questions.  To learn more about how to get started investing with a self-directed IRA, schedule a 1-on-1 consultation with an IRA Specialist by clicking HERE.

Active vs Passive: What Type of Self-Directed IRA Investor Are You?

One of the biggest benefits of real estate investing with a Self-directed IRA is the ability to have extreme flexibility no matter what type of lifestyle you have. Some people are full time investors, and love to spend all of their time searching for new rental properties or their next rehab project! But others simply don’t have enough time. With day-to-day life constantly moving, the thought of taking the time to find a property to invest in may sound daunting, which is why a more passive approach is appealing. The good news is, no matter what type of investing you prefer, Self-Directed IRAs offer something for everyone! 

Investing in What You Know Best

When getting involved in any investment, you always want to make sure you’re doing the best deal for you! Investing in things you are interested in and are familiar with will usually yield the highest returns. When you invest in things you don’t fully understand, you run the risk of doing something wrong. If you don’t like the investment, you won’t have any interest in it, which could mean losing money, as well. Taking the time to stop and think about what you are good at will typically help produce better results for your Self-Directed IRA.

Active vs. Passive: What Works for You?

As mentioned, your lifestyle plays a big role in the way you invest, too. A lot of investors still have a regular day job and can’t afford to dedicate all of their time to their retirement account.  Passive investors can maximize their IRAs by finding investments that don’t take much daily maintenance. For others, real estate is a full time job, and doing a few deals in their SDIRA in addition comes easy.  These active investors can afford to offer more time to their investments. Common things that passive investors would dread, like dealing with tenants or property repairs isn’t as big of a hassle for active investors, since they usually have more availability.

What Investment Are Good For My Investing Style?

So, what type of investments would be good for you? Let’s analyze. As passive investing grows in popularity, more people are maximizing their Self-Directed IRAs with non-traditional passive investments. Real estate notes and private loans secured by property can be a great investment for the busy investor that can’t actively invest in real estate the traditional way. Multifamily and other private entity deals (i.e. include LLCs, limited partnerships, trusts, private stock, etc.) are also quite passive and don’t require much work from the Self-Directed IRA investor, making these great opportunities, as well. 

Active investors may prefer to seek out physical property, using their Self-Directed IRAs to purchase rehabs or potential rental properties. Wholesaling and fix-and-flipping are gaining popularity among IRA investors, too. The beauty of real estate is that it offers safety and security by being a tangible asset. You can drive by a property and actually see, touch, and feel the investment, which gives active investors assurance. Below is a helpful chart that can help you weigh which option might be best for you.

Investing is different for everyone. There will be pros and cons for whatever type of investment appeals to you. In the event something were to go wrong with your investments, understanding what to do will also help you determine if the investment is right for you. Most important thing to do is find an investment that you like and are comfortable with. If you have questions about starting your Self-Directed IRA to invest actively or passively in real estate, schedule a 1-on-1 consultation with an IRA Specialist by clicking HERE.

Everything You Want to Know About Traditional IRA RMDs

If you have been contributing to a Traditional IRA, eventually you will need to take yearly required minimum distributions (RMDs). The first RMD is required the year you turn 72, and they continue each year after that. Roth IRAs don’t require RMDs, since those contributions were made post-tax. RMDs on Traditional IRAs are the government’s way of ensuring they get their tax money from investors. Usually, investors make contributions to their IRA pre-tax, and they can write off the contribution on their taxes. When they take a distribution, they are taxed on the money based on their income levels. More frequently asked questions about RMDs are answered below.

How Do I Calculate My RMD?

The IRS uses a special table to calculate your RMD. Basically, they take the fair market valuation of your IRA and divide it by your life expectancy. You can view the charts here and make a worksheet outlining your RMDs near the bottom of the page. Some institutions allow investors to automatically withdraw the RMD from their account each year so plan owners don’t have to worry about figuring out the exact amount to withdraw each year.

Can I Withdraw More than the RMD?

Plan owners are allowed to withdraw more than their RMD each year, but this may bump them to a higher tax bracket at tax time. Extra distributions also do not count toward next year’s RMD.

What if I Have More Than One Account with RMDs?

If you have more than one account requiring RMDs, such as a Traditional IRA and a 401(k), then you can take your distributions from either account. The total amount must line up with what the IRS requires of you for the year, but you could take it all from one account or split it between both.

What is the Penalty for Not Taking an RMD?

If you didn’t take an RMD, or you missed the deadline, the IRS will penalize you up to 50% of what the RMD was. So, if you needed to take out $20,000, but missed the deadline, the IRS could penalize you $10,000. For more information on this topic, read our article What to do if You’ve Missed an RMD on an IRA.

Am I Taxed on My RMD?

If you made tax-deductible contributions, those contributions and your earnings will be taxed when you take your RMD. If you made contributions post-tax, then you won’t be taxed again on that portion of your distribution, but you will still be taxed on your earnings from the account.

What Can I Do with the Money if I Don’t Need it for Living Expenses?

If your RMD is more than what you need for living expenses, there are a few options you can do with the extra funds. The most popular options people choose are contributing the funds into a college savings plan or converting into a Roth IRA if they qualify.

Simple Rules for Beginner IRA Investing

For big companies, retirement investing isn’t something that employees have to put a lot of thought into. They have their 401(k) plans set up for you can you just have to decide a few of the smaller details. But when it comes to investing in an IRA, there is a lot more that goes into the decisions you have to make.

Not only are you getting the chance to decide between Roth IRAs and Traditional IRAs, you also get to decide what you want to invest in and how much you’re willing to invest. IRAs are unique because you are able to invest in a much wider variety of things rather than the limited investments you can make with other retirement plans. With this expanded selection of choices, however, there are a few things you’ll want to know when IRA investing. Below are some simple ‘rules’ per se to follow for beginner investors.

1. Know what risks you’re willing to take. When investing in anything, one of the most important things to remember is that there is always a risk that comes with it. Investing in high risk stocks can have a higher pay off, but there is also a chance that you could lose a lot of money. Investing in bonds is very low risk, but you also will have less of a reward. If you are willing to take some risks, make sure you know how far you are willing to go. It is also important to remember that the market is constantly changing, so the value of your investments will be moving fluctuating constantly.

2. Decide on an asset allocation that is right for you. Age can have a huge impact on how you invest. If you are just starting to invest and you are a long way off from retirement, you can take more risks because you’ll have more time for them to pay off. However, if retirement is quickly approaching, you’ll probably want to protect your assets. So, low risk investments will be better in this case. You can decide what percentage of your assets you want in different categories based on how much risk you are willing to take.

3. Using professional investors is okay. If you do not know much about the current market and selecting funds and stocks to invest in, it is okay to consult a professional. Not only will this save you time, it can also earn you a lot more money for retirement than if you were to invest yourself. While you may have to pay some small fees for this, the benefits of outsourcing will likely pay for itself several times over.

However you chose to invest, the biggest thing to remember is to think long term. Your retirement funds don’t grow overnight. The market is always changing. While your investments may rise and fall over the years, the general trend is always up, so don’t lose heart if the market is in a down trend. Investing in an IRA doesn’t have to be hard or scary if you keep yourself informed and follow these tips.

Two Ways to Invest in Promissory Notes with Your IRA

Promissory notes are alternative methods for businesses and individuals to obtain funds if they don’t qualify for a traditional bank loan. They are basically an official and legally binding IOU. The owner of an IRA can use their IRA funds to finance these notes, and they have the authority to set specific terms to the agreement. IRA owners can decide the term length (how long the borrower has to pay them back), the interest rate, the dates for when each repayment is due, and even consequences in the event the borrower fails to meet these requirements.

Promissory notes can help IRA owners diversify their portfolio with a long-term investment. Since promissory notes have high interest rates, IRA owners typically earn high rewards on these investments when they reach maturation. They can also guarantee cash flow for years, as the borrower must make the payments on time.

Like any investment, not all promissory notes are sure investments. If the borrower defaults, especially on an unsecured note, the IRA owner could lose on the investment. It’s important to research the borrower and discuss this option with your broker before investing in promissory notes. Secured notes are safer since they will include collateral, but unsecured notes allow for higher interest rates and returns on the investment. Generally, promissory notes are only an available option through self-directed IRAs, and there are two ways IRA owners can invest in a promissory note.

Promissory Notes for Businesses

When businesses have used all other means for securing funds but still need another option to keep running, they can obtain credit through promissory notes. Some industries are inherently riskier than others, and it is recommended that IRA owners investing in corporate promissory notes have knowledge or experience in the field beforehand to make an informed decision. With corporate promissory notes, the IRA owner can stipulate that the repayment be made with cash or with equity in the company itself. IRA owners can also ask for equity in the company or other business assets if the business defaults on the loan. This can help IRA owners protect their investment, and/or provide options to both the IRA owner and borrower for repayment.

Mortgage Promissory Notes

If a home buyer doesn’t qualify for a traditional bank mortgage loan, they may have the option of purchasing a home directly from the seller through a promissory note. The seller will keep the mortgage and the deed of the home while the buyer makes fixed payments to them while residing in the home. If they default on their payments, the seller, who still has the deed, keeps the home as collateral. However, if the buyer fulfills the terms and continues to pay, they legally own the home. This also ensures continual income with interest for the IRA owner as long as the buyer doesn’t default.

Promissory notes are typically only available through self-directed IRAs, but can help investors diversify their portfolios and guarantee income for the time specified in the agreement. Talk to your financial advisor to see if promissory notes line up with your long-term and retirement goals.

Why You Might Consider A Non-Deductible Self-Directed IRA

Tax deductibility of annual contributions has always been one of the biggest selling points of traditional IRAs, self-directed IRAs included. This tax break is often the deciding factor that gets some individuals to adjust their budgets or forego discretionary spending in order to save for their own retirement future.

But the Roth IRA, even though contributions to it can never be deducted, can still be extremely valuable (and for some individuals, even more valuable). Even non-deductible contributions to a traditional account can provide you with significant long-term tax savings. If you’re faced with the prospect of having to make a non-deductible IRA contribution this year, here are some reasons to go ahead and do so.

Tax-Free or Tax-Deferred Investment Growth. It’s important to understand that while there’s unmistakable value to the current year tax break you might get from a deductible contribution, you may get greater value from the tax-free investment growth that a Roth IRA can provide.

Consider that even though you don’t have to pay income tax on the investment gains you realize within a traditional self-directed IRA, you will eventually have to pay taxes on those gains when you take a distribution of those funds. And that total tax bill can be significant, given how much your account can grow over time.

In contrast, distributions that are taken from a Roth IRA never incur a tax liability, provided you’ve reached full retirement age. This is a unique situation in the tax law – never having to pay taxes on investment gains – and the financial benefit can be quite substantial.

To Maximize Your Retirement Savings. The more money you can accumulate for retirement, the better. When you make a non-deductible contribution to a self-directed IRA (whether it’s a Roth or even to a traditional account), you’ll still be able to invest and grow that money on a tax-deferred (in the case of a traditional account) or tax-free (in the case of a Roth account) basis.

Just remember that if you make both deductible and non-deductible contributions to a single traditional account you’ll face some potentially challenging record keeping obligations in order to determine what portions of your future distributions are subject to tax, and which are not. Some retirement savers choose to get around this administrative headache by simply having a Roth account as well as a traditional self-directed IRA.

So, when are you likely to be faced with having to make non-deductible contributions? You may find that you’re ineligible for the tax deduction if your income is too high in a particular year, and that income threshold will be lower if you participate in a 401(k) through your employer. Whatever the reason, the best way to build your retirement nest egg is to save the maximum amount you can to your self-directed IRA every single year, whether you can take a tax deduction for the contribution or not.

Six Widely Held Untruths About Self Directed IRAs

By H. Quincy Long for Self-Directed Source Blog

There is a lot of confusion over self-directed IRAs and what is and is not possible. In this article we will discuss six of the biggest self-directed IRA myths.

1)      Purchasing anything other than CDs, stocks, mutual funds or annuities is illegal in an IRA.

FALSE! According to the Internal Revenue Code for IRAs, the only disallowed investments are life insurance contracts and in “collectibles”, which are defined by the IRS to include any work of art, any rug or antique, any metal or gem (with certain exceptions for gold, silver, platinum or palladium bullion), any stamp or coin (with certain exceptions for gold, silver, or platinum coins issued by the U.S. or under the laws of any State), any alcoholic beverage, or any other tangible personal property specified by the Secretary of the Treasury (no other property has been specified as of this date).

With so few restrictions contained in the law, almost anything else which can be documented can be purchased in your IRA. A “self-directed” IRA allows any investment not expressly prohibited by law. Common non-traditional investment choices include real estate, both domestic and foreign, options, secured and unsecured notes, including first and second liens against real estate, C corporation stock, precious metals, limited liability companies, limited partnerships, trusts and a whole lot more.

2) Only Roth IRAs can be self-directed.

False. Because of the superior tax-free wealth accumulation in a self-directed Roth IRA, many articles are written on how to use a Roth IRA to invest in non-traditional investments. As a result, it is a surprisingly common misconception that a Roth IRA is the only account that can be self-directed. In fact, there are seven different types of accounts that can be self-directed. They include the 1) Roth IRA, 2) the Traditional IRA, 3) the SEP IRA, 4) the SIMPLE IRA, 5) the Individual 401(k), including the Roth 401(k), 6) the Coverdell Education Savings Account (ESA, formerly known as the Education IRA), and 7) the Health Savings Account (HSA). Not only can any of these accounts invest in non-traditional investments as indicated in Myth 1, but they can be combined to purchase a single investment.

3) I don’t qualify for a self-directed Roth or Traditional IRA because I am covered by a retirement plan at work or because I make too much money.

False. Almost anyone can have a self-directed account of some type! Although there are income limits for contributing to a Roth IRA (in 2021 the income limits are $208,000 for a married couple filing jointly and $139,000 for a single person or head of household), having a plan at work does not affect your ability to contribute to a Roth IRA, and there is no Roth IRA age limit either. With a Traditional IRA, you or your spouse having a retirement plan at work does affect the deductibility of your contribution, but anyone with earned income who is under age 72 can contribute to a Traditional IRA. There are no upper income limits for contributing to a Traditional IRA. Also, a Traditional IRA can receive funds from a prior employer’s 401(k) or other qualified plan. Additionally, you may be able to contribute to a Coverdell ESA for your children or grandchildren, nieces, nephews or even my children, if you are so inclined. If you have the right type of health insurance, called a High Deductible Health Plan, you can contribute to an HSA regardless of your income level. With an HSA, you may deduct your contributions to the account and qualified distributions are tax-free forever! It’s the best of both worlds. All of this is in addition to any retirement plan you have at your job or for your self-employed business.

4) If I want to purchase non-traditional investments in an IRA, I must first establish an LLC which will be owned by my IRA.

False. A very popular idea in the marketplace right now is that you can invest your IRA in an LLC where you (the IRA owner) are the manager of the LLC. Effectively you have “checkbook control” of your IRA funds. Providers generally charge thousands of dollars to set up these LLCs and sometimes mislead people into thinking that this is necessary to invest in real estate or other non-traditional investments. This is simply not true. Not only can an IRA hold title to real estate and other non-traditional investments directly with companies such as Entrust Retirement Services, Inc., but having “checkbook control” of your IRA funds through an LLC can lead to many traps for the unwary. Far from protecting your IRA from the prohibited transaction rules, these setups may in fact lead to an inadvertent prohibited transaction, which may cause your IRA to be distributed to you, sometimes with substantial penalties. This is not to say that there are not times when having your IRA make an investment through an LLC is a good idea, especially for asset protection purposes. Nonetheless, you must educate yourself completely as to the rules before deciding on this route. Having a “checkbook control” IRA owned LLC is kind of like skydiving without a parachute – it may be fun on the way down, but eventually you are likely to go SPLAT!

5) Because I have a small IRA and can only contribute $6,000, it’s not worth having a self-directed IRA.

False. Even small accounts can benefit from non-traditional investing. Small accounts can be co-invested with larger accounts owned by you or even others. For example, one recent hard money loan we funded had 10 different accounts participating. The smallest account to participate was for only $1,827.00! There are at least 4 ways you can participate in real estate investment even with a small IRA. First, you can wholesale property.  Simply put the contract in the name of your IRA instead of your name, and have the earnest money come from the IRA. Then, when you assign the contract, the assignment fee goes back into your IRA. Second, you can purchase an option on real estate, which then can be either exercised, assigned to a third party, or canceled for a fee. Third, you can acquire property in your IRA subject to existing financing or using a non-recourse loan from a bank, a hard moneylender, a financial friend or a motivated seller. Realize, however, that profits from debt-financed property in your IRA may incur unrelated business income tax (UBIT). Lastly, as mentioned above, your IRA can partner with other IRA or non-IRA investors.

6) An IRA cannot own a business.

False. A self-directed IRA is an astoundingly flexible wealth building tool, and it can own almost anything, including a business. However, due to the conflict of interest rules you cannot work for a business owned by your IRA and get paid. Some companies have a plan to start a C corporation, adopt a 401(k) plan, roll an IRA into the 401(k) plan and purchase employer securities to effectively start a new business, but this is not a direct investment by the IRA in the business and is fairly expensive to set up. Also, if your IRA owns an interest in a business, either directly or indirectly through a non-taxed entity such as an LLC or partnership, the IRA may owe Unrelated Business Income Tax (UBIT) on its profits from the business. A solution to this problem may be to have the business owned by a C corporation or another taxable entity.

Why Your IRA May Owe Taxes: To Pay or Not to Pay? – That is the Question

By: H. Quincy Long

A. Introduction

Many people are surprised to learn that, as discussed below, there are 2 ways in which an IRA or 401(k) investment in an entity may cause the retirement plan to owe tax on its income or profits from that investment. This does not necessarily mean that you should not make an investment which subjects your retirement plan to taxation. It does mean that you must evaluate the return on the investment in light of the tax implications.

B. Unrelated Business Income (UBI)

The first situation in which a retirement plan might owe tax on its investment is if the entity invested in is non-taxable, such as a limited partnership or an LLC treated as a partnership for tax purposes, and the entity operates a business. Although investment in an entity which is formed for the purpose of capital investment, such as the purchase and holding of real estate, should not generate taxable income for the retirement plan (unless there is debt financing, as discussed below), any income from business operations would be considered Unrelated Business Income (UBI) for the plan. UBI is the income from a trade or business that is regularly carried on by an exempt organization and that is not substantially related to the performance by the organization of its exempt purpose, with the exception that the organization uses the profits derived from this activity. Exclusions from UBI include dividends, interest, annuities and other investment income, royalties, rents from real property (but not personal property), income from certain types of research, and gains and losses from disposition of property (except property which is considered to be inventory).

Example. Ira N. Vestor has a large rollover IRA from a former employer and wants to help out his friend, Will B. Richer, who is starting a new restaurant business. Will offers Ira a 25% ownership interest in his new business, Eat Richer Restaurants, LLC. Ira believes Will is going to be a huge success, and wants to grow his IRA. The LLC will be taxed as a partnership. Ira will not be paid and will have no part in the management or operation of the business. Because the LLC is taxed as a partnership, the IRA must pay taxes on its share (whether or not distributed) of the gross income of the partnership from such unrelated trade or business less its share of the partnership deductions directly connected with such gross income.[1]

C. Unrelated Debt Financed Income (UDFI)[2]

A second situation in which a retirement plan may owe tax is when the plan or an entity invested in by the plan owns debt financed property. Anytime a retirement plan owns debt financed real estate (with a possible exception for 401(k) plans, discussed below), either directly or indirectly through a non-taxable entity, the income from that investment is taxable to the retirement plan as Unrelated Debt Financed Income (UDFI). The amount of income included is proportionate to the debt on the property. Your retirement plan is only taxed on the debt financed portion and not the entire amount of income.

Definition of “Debt Financed Property.” In general, the term “debt-financed property” means any property held to produce income (including gain from its disposition) for which there is an acquisition indebtedness at any time during the taxable year (or during the 12-month period before the date of the property’s disposal if it was disposed of during the tax year). If your retirement plan invests in a non-taxable entity and that entity owns debt financed property, the income from that property is attributed to the retirement plan, whether or not the income is distributed.

Calculation of UDFI. For each debt-financed property, the Unrelated Debt Financed Income is a percentage of the total gross income derived during a tax year from the property. The formula is as follows:

Average Acquisition Indebtedness x Gross Income from

Average Adjusted Basis Debt-Financed Property

Once the gross UDFI is calculated as above, your retirement plan is entitled to most normal income tax deductions including expenses, straight line depreciation and similar items that are directly connected with income from the debt financed property, plus an automatic deduction of $1,000.

Capital Gains Income. The good news is that if there has been no debt owed on the property for at least 12 months prior to the sale, there is no tax on the capital gains. However, if a retirement plan or a non-taxable entity owned by the retirement plan sells or otherwise disposes of debt-financed property and there has been acquisition indebtedness owed within 12 months prior to the date of sale, the retirement plan must include in its taxable income a percentage of any gain or loss. The percentage is that of the highest acquisition indebtedness with respect to the property during the 12-month period preceding the date of disposition in relation to the property’s average adjusted basis. The tax on this percentage of gain or loss is determined according to the usual rules for capital gains and losses. This means that long term capital gains are taxed at a lower rate than short term capital gains.

Example. Ira N. Vestor wants to use his IRA to invest in a limited partnership, Payor Go, L.P., which will purchase an apartment complex. The lender requires a 20% cash down payment, and will not permit subordinate financing. Because the property is 80% debt financed, Mr. Vestor’s IRA will owe a tax on approximately 80% of its net profits from the limited partnership (the percentage subject to tax changes as the debt is paid down and the basis is adjusted). When the property sells, Mr. Vestor’s IRA will have to pay capital gains tax on the debt financed portion of the profits. Only the profits from the rents or capital gains from the sale that are attributable to the debt financing are taxable to the IRA. For example, if the gain on the sale of the apartment complex is $100,000, and the highest acquisition indebtedness in the 12 months prior to the sale divided by the average adjusted basis is 75%, then $25,000 of the gain is tax deferred or tax free as is normal with IRA’s, while the IRA would owe tax (not Mr. Vestor personally) on $75,000.

D. Exemption From Taxes on UDFI for 401(k) Plans

One piece of great news for those with self-directed 401(k) plans is that plans under §401 of the Internal Revenue Code (IRC) enjoy an exemption from the tax on UDFI in certain circumstances. This exception to the tax is found in IRC §514(c)(9), and applies only to “qualified organizations.” Qualified organizations include certain educational organizations and their affiliated support organizations, a qualified pension plan (ie. a trust qualifying under IRC §401), and a title-holding company under IRC §501(c)(25), but only to the extent it is owned by other qualified organizations. IRAs are trusts created under IRC §408, not IRC §401, so the real estate exception to the UDFI tax does not apply to IRAs. The good news is that plans such as the Quest Individual (k) Plan do qualify for this exception under the right circumstances.

There are six basic restrictions which must be met for the exemption from the UDFI tax to apply. They are:

1) Fixed Price Restriction. The price for the acquisition or improvement must be a fixed amount determined as of the date of the acquisition or the completion of the improvement.

2) Participating Loan Restriction. The amount of any indebtedness or any other amount payable with respect to such indebtedness, or the time for making any

3) payment of any such amount, must not be dependent, in whole or in part, upon any revenue, income, or profits derived from such real property.

4) Sale and Leaseback Restriction. The real property must not at any time after the acquisition be leased by the qualified organization to the seller of the property or to certain related persons, with certain small leases disregarded.

5) Disqualified Person Restriction. For pension plans, the real property cannot be acquired from or leased to certain disqualified persons described in 4975(e)(2), with certain small leases disregarded.

6) Seller Financing Restriction. Neither the seller nor certain related disqualified persons may provide financing for the acquisition or improvement of the real property unless the financing is on commercially reasonable terms.

7) Partnership Restrictions. Partnerships must meet any one of three tests if the exemption from the tax on UDFI is to apply to the qualified organizations who are partners. First, all of the partners can be qualified organizations, provided none of the partners has any unrelated business income. Second, all allocations of tax items from the partnership to the qualified organizations can be “qualified allocations,” which means that each qualified organization must be allocated the same distributive share of each item of income, gain, loss, deduction, credit and basis. These allocations may not vary while the qualified organization is a partner in the partnership, and must meet the requirement of having a “substantial economic effect.” Third, and perhaps most commonly, the partnership must meet a complex test called the “Fractions Rule” (or the “Disproportionate Allocation Rule”).

Even with the restrictions, there are circumstances where this exemption can work. For example, one client rolled over her IRA into a 401(k) plan she created for her home based interior decorator business. The 401(k) plan then purchased 2 apartment buildings with non-recourse seller financing (which was on commercially reasonable terms). Not only is the 401(k)’s rental income exempt from the tax on UDFI, but so will the capital gains be exempt. If there is a concern about asset protection, a title holding §501(c)(2) or §501(c)(25) corporation can be formed, and the exemption will still apply.

E. Frequently Asked Questions on Unrelated Business Income Tax (UBIT)

Q. If the profits from an investment are taxable to an IRA, does that mean it is prohibited?

A. Absolutely not! There is nothing prohibited at all about making investments in your IRA which incur tax.

Q. But if an investment is taxable, why make it in the IRA?

A. That is a good question. To figure out if this makes sense, ask yourself the following key questions. First, does the return you expect from this investment even after paying the tax exceed the return you could achieve in other non-taxable investments within the IRA? For example, one client was able to grow her Roth IRA from $3,000 to over $33,000 using debt financed real estate in under 4 months even after the IRA paid taxes on the gain! Second, what plans do you have for re-investing the profits from the investment? If you re-invest your profits from an investment made outside of your IRA you pay taxes again on the profits from the next investment, and the one after that, etc. At least within the IRA you have the choice of making future investments which will be tax free or tax deferred, depending on the type of account you have. Third, what would you pay in taxes if you made the same investment outside of the IRA?[3] The “penalty” for making the investment inside your IRA, if any, is only the amount of tax your IRA would pay which exceeds what you would pay personally outside of your IRA. Unlike personal investments, the IRA owes tax only on the portion of the net income related to the debt, so depending on how heavily leveraged the property is the IRA may actually owe less tax than you would personally on the same investment.

Q. If the IRA pays a tax, and then it is distributed to me and taxed again, isn’t that double taxation?

A. Yes, unless it is a qualified tax free distribution from a Roth IRA, a Health Savings Account (HSA) or a Coverdell Education Savings Account (ESA). The fact is that you still want your IRA to grow, and sometimes the best way to accomplish that goal is to make investment which will cause the IRA to pay taxes. Also, bear in mind that companies which are publicly traded also pay taxes before dividends are paid, and the value of the stock takes into consideration the profits after the payment of income taxes. In that sense, even stock and mutual funds are subject to “double taxation.” In my view, the double taxation issue should not be your focus, but rather merely a factor in your analysis. Is the IRA glass 1/3 empty or 2/3 full? At least the IRS is a silent partner.

Q. If the IRA makes an investment subject to tax, who pays the tax?

A. The IRA must pay the tax.

Q. What form does the IRA file if it owes taxes?

A. IRS Form 990-T, Exempt Organization Business Income Tax Return.

Q. What is the tax rate that IRAs must pay?

A. The IRA is taxed at the rate for trusts. Refer to the instructions for IRS Form 990-T for current rates. Remember, in the case of UDFI the IRA only pays tax on the income attributable to the debt and not 100% of the income.

Q. Where can I find out more information?

A. Visit our website at www.QuestIRA.com for more information. Also, Unrelated Business Taxable Income and Unrelated Debt Financed Income are covered in IRS Publication 598, which is freely available on the IRS website at www.irs.gov. The actual statutes may be found in Internal Revenue Code §511-514.

F. Solutions to the UBIT “Problem”

Is there any way to get around paying this tax? The short answer is yes. Investments can often be structured in such a way as to avoid taxation. Dividends, interest, investment income, royalties, rents from real property (but not personal property), and gains and losses from disposition of property (unless the property is debt financed or is considered “inventory”) are all excluded from the calculation of taxable income to the retirement plan. Some examples of how you might structure a transaction in ways that are not taxable to the retirement plan include:

Example. Suppose in the Eat Richer Restaurants, LLC example above the LLC elected to be treated as a corporation instead of a partnership, or a C corporation was formed instead (IRA’s may not own shares of an S corporation). Because the entity has already paid the tax, the dividend to the IRA would be tax free or tax deferred. This may not be acceptable to other shareholders, however.

Example. Instead of his IRA directly in Pay or Go, LP, Ira N. Vestor could have made a loan instead. The loan could have been secured by a second lien on the property (which may not be permitted by the first lienholder, however). The loan could even be secured by shares of the LP itself, possibly with a feature allowing the loan to be converted at a later point to an equity position in the LP (a “convertible debenture”). Caution: With lending there may be state or federal usury limits on how much interest may be charged, and if the debt is converted into equity the IRA may then owe taxes at that time.

Example. Another choice for investing without the IRA paying taxes is to purchase an option instead. When your IRA owns an option to purchase anything, it can 1) let it lapse, 2) exercise the option, 3) sell or assign the option (provided the option agreement allows this) or 4) release the owner from the option for a fee (in other words, getting paid not to buy!).

G. Conclusion

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. 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!”

Frequently Asked Questions About Buying Debt Financed Real Estate in an IRA

Good news!  You can buy real estate in your traditional, Roth, SEP, or SIMPLE IRA, your 401(k), your Coverdell Education Savings Account for the kids, and even in your Health Savings Account.  Even better, your IRA can borrow the money for the purchase or even take over a property subject to existing financing.  What could be better than building your retirement wealth using OPM (Other People’s Money)?  However, there are some restrictions which you must be aware of when using your IRA to purchase debt financed real estate.  Below I answer a series of frequently asked questions regarding the purchase of debt financed real estate in an IRA.
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Q.        Is it really legal to buy real estate in an IRA?

A.        Yes.  Even the IRS agrees that real estate is a permitted investment.  In its answer to the question “Are there any restrictions on the things I can invest my IRA in?” the Internal Revenue Service states “IRA law does not prohibit investing in real estate but trustees are not required to offer real estate as an option.”

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Q.        Can my IRA buy real estate with a loan or take over a property subject to an existing loan?

A.        Yes.  An IRA may borrow money to acquire real estate or take over a property subject to an existing loan, provided that the loan is non-recourse to the IRA and to any “disqualified person.”  This means that typically the lender may only foreclose on the property in the event of a default.  Even if there is a deficiency, the lender cannot come after the rest of the IRA’s assets, nor can the lender come after the IRA owner or any other disqualified person.  Neither the IRA holder nor any other disqualified person is permitted to sign a personal guarantee of the debt.

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Q.        Where can I get a non-recourse loan for my IRA?

A.        There are at least four sources for financing which do not violate the non-recourse requirements for IRA’s.  First, there is seller financing.  Most sellers understand that if the loan goes into default they get the property back anyway, so asking for the loan to be non-recourse should not be too difficult to negotiate.  Second, there is private financing from financial friends.  If you cultivate a reputation as a professional real estate investor, there should be no reason that your financial friends would not loan your IRA money on a non-recourse basis, either from their own funds or from their own IRA’s.  I have seen

IRA’s borrow the money for both the purchase and the rehab on a non-recourse loan!  Third, there are banks and hard money lenders.  Non-recourse loans are not the norm, so many banks will turn you down.  However, there is at least one bank that lends in all 50 states, and in Houston I have had at least 3 local banks and 2 hard money lenders make non-recourse loans to IRA’s.  Finally, as mentioned above, you could take over a property subject to an existing loan, provided the originator of the loan is not you or another disqualified person.

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Q.        Is there any tax effect of having an IRA own debt financed real estate?

A.        Yes.  Income and gains from investments in an IRA, including real estate, are normally not taxed until the income is distributed (unless the distribution is a qualifying distribution from a Roth IRA, a Coverdell Education Savings Account, or a Health Savings Account, in which case the distribution is tax free).  However, if the IRA owns property subject to debt, either directly or indirectly through an LLC or a partnership, it may owe tax on the net income from the property or partnership.

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Q.        If the profits from an investment are taxable to an IRA, does that mean it is prohibited?

A.        Absolutely not!  There is nothing prohibited at all about making investments in your IRA which will cause the IRA to owe taxes.

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Q.        But if an investment is taxable, why do it in the IRA?

A.        That is a good question.  To figure out if this makes sense, ask yourself the following key questions.  First, what would you pay in taxes if you made the same investment outside of the IRA?  The “penalty” for making the investment inside your IRA, if any, is only the amount of tax your IRA would pay which exceeds what you would pay personally outside of your IRA.  Unlike personal investments, the IRA owes tax only on the portion of the net income related to the debt, so depending on how heavily leveraged the property is the IRA may actually owe less tax than you would personally on the same investment.  Second, does the return you expect from this investment even after paying the tax exceed the return you could achieve in other non-taxable investments within the IRA?  For example, one client was able to grow her Roth IRA from $3,000 to over $33,000 using debt financed real estate in under 4 months even after the IRA paid taxes on the gain!  Third, do you have plans for re-investing the profits from the investment?  If you re-invest your profits from an investment made outside of your IRA you pay taxes again on the profits from the next investment, and the one after that, etc.  At least within the IRA you have the choice of making future investments which will be tax free or tax deferred, depending on the type of account you have.

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Q.        If the IRA pays a tax, and then it is distributed to me and taxed again, isn’t that double taxation?

A.        Yes, unless it is a qualified tax free distribution from a Roth IRA, a Health Savings Account (HSA) or a Coverdell Education Savings Account (ESA).  The fact is that you still want your IRA to grow, and sometimes the best way to accomplish that goal is to make investments which will cause the IRA to pay taxes.  Keep in mind that companies which are publicly traded already have paid taxes before dividends are distributed, and the value of the stock takes into consideration the profits after the payment of income taxes.  In that sense, even stock and mutual funds are subject to “double taxation.”

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Q.        If the IRA makes an investment subject to tax, who pays the tax?

A.        The IRA must pay the tax.

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Q.        What form does the IRA file if it owes taxes?

A.        IRS Form 990-T, Exempt Organization Business Income Tax Return.

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Q.        What is the tax rate that IRA’s must pay?

A.        The IRA is taxed at the rate for trusts.  Refer to the instructions for IRS Form 990-T for current rates.

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Q.        Is there any way to get around paying this tax?

A.        Yes.  In some ways it may be considered a “voluntary” tax, since investments can often be structured in such a way as to avoid taxation.  Some ways to structure your IRA investment to avoid taxation include loaning money instead of acquiring the real estate directly or purchasing an option on the real estate, then assigning or canceling the option for a fee.  These techniques have a disadvantage in that they may not result in as much profit to the IRA, but will generally be free of tax.  There is also an exemption from this tax for 401(k)’s and other qualified plans in certain circumstances.

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Q.        Where can I find out more information?

A.        Visit our website at www.QuestIRA.com for more information.  Also, Unrelated Business Taxable Income and Unrelated Debt Financed Income are covered inIRS

Publication 598, which is freely available on the IRSwebsite at www.irs.gov.  The actual statutes may be found in Internal Revenue Code §511-514.

There is one general truth that applies both inside and outside of an IRA – you can do more with debt than you can without it.  Despite the increased risk from debt and the taxes due on income from debt financed property, a careful analysis may lead to the conclusion that having your IRA pay taxes now may be the way to financial freedom in your retirement.  Be sure to have your IRA pay the tax if it owes it, though.  As I always say, “Don’t mess with the IRS, because they have what it takes to take what you have!”

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