Tips For Managing A Large Real Estate Portfolio In Your Self-Directed IRA

Real estate is a perennially popular investment type for individuals to pursue within their self-directed IRAs. The ability to invest in real estate – both developed and undeveloped properties – can provide an investment and risk profile that generally can’t be mirrored with traditional stock market investments.

But holding real estate within a self-directed IRA can also require a greater level of investment involvement as compared to those other asset classes.

With stocks or mutual funds, the only investor decision is generally just whether to buy or sell. But with real estate, you’ll need to take a much more active role in your investment. And as your real estate portfolio grows ever larger (as is often the case, because many investors view real estate as the ultimate “buy and hold” asset, and therefore tend to add to their positions more than they sell existing investments), you will want to make sure you’re managing your portfolio as efficiently and effectively as possible.

1. Have a Plan.
One of the biggest differences between real estate investments and other investment types is simply the transaction costs associated with making the investments. You can buy stocks, for example, and pay a relatively small commission – and if you quickly change your mind about the suitability of that investment you can sell it the next day and similarly pay a similarly small commission. That’s not the case when it comes to real estate. You need to do your research and planning ahead of time to be comfortable that you’re making the right decision.
You may also wish to consider how subsequent additions to your real estate portfolio in terms of risk and exposure to particular market downturns will affect you. For example, if you own multiple units in a single neighborhood or very small geographic area, then you’re bearing risks (both to the upside and downside) associated with that area’s growth.

2. Stay Active.
By “staying active” we mean that you’ll want to stay on top of your investments and frequently monitor the local market conditions, the condition of the property, and that your tenants are meeting all of their tenant obligations. The value of your investment can erode over time if you’re not paying close enough attention. When you monitor your investments you may also be able to identify opportunities or efficiencies to be gained across multiple real estate investments in your account.

3. Seek Out Professional Assistance.
The larger your real estate portfolio, the more you stand to gain by using a professional property management service. While you’re permitted to perform repair and management related tasks on your own investments, you can’t compensate yourself for your time or effort – doing so would constitute a prohibited “self-dealing” transaction. This is true even if you’re in the business of providing these services to other clients.

But you can hire an outside company or individual (provided they’re not related to you) to perform these services. Not only might that just bring a higher level of professionalism and service to your investments, it can also save you time and energy by not having to manage a growing portfolio yourself.

Selecting Your First Real Estate Investment For Your Self-Directed IRA

Let’s say that like many individuals who are setting up their first self-directed IRA, perhaps drawn to the offerings of custodians such as Quest Trust Company because of the investment flexibility that such an account gives, you’re interested in using your new account to invest in real estate.

What are the next steps? How do you go about choosing your first real estate investment for your self-directed IRA?
What’s Your Prior Experience? When it comes to any new investment, there’s always some degree of learning as you go. But if you have very little or no experience with owning or managing real estate, then you may want to consider a more straightforward property for your first self-directed IRA investment.

What’s Your Investment Budget? Another key consideration is going to be the size of the investment budget for your first property. The more money you have available, the more options you’ll have.

As you formulate your budget, be sure to take into account the fact that any expenses for maintaining the property you buy must also come from within your self-directed IRA. This might be new contributions you are able to make each tax year, but these are subject to the annual contribution limits. Plan to either have your real estate generate enough income to pay for these expenses, or to incorporate other assets into your account in order to cover the real estate carrying costs.

What’s Your Current Portfolio Composition? Regardless of your preferred investment type, you always need to take care to avoid having too much of your portfolio committed to a single asset class. If you already have exposure to real estate in your portfolio (perhaps through banking stocks or REITs), then you want to factor that into your new investment considerations.

What’s the Purpose of the Real Estate Investment? Are you considering this real estate investment solely for potential gains, or do you have other goals in mind? For example, some people use their self-directed IRAs to purchase vacation or other properties that they intend to use themselves once they reach retirement age.

As you consider these types of investments, remember that the IRS regulations prohibiting self-dealing, meaning that you cannot use (nor can anyone in your family use) the property you buy until you take a distribution of it from your account during retirement (or face significant penalties if you take that distribution prior to retirement).

Start Small. Many first-time investors find that the best way to become more familiar with investing in real estate is to start small. This might be a single-family home, or even a condominium. Having a small investment in real estate can give you the opportunity to learn more first-hand, without over-committing your retirement portfolio to this type of asset.

Even though real estate is a fairly unique investment asset, it’s still subject to traditional financial analysis. Make sure you familiarize yourself with the local and broader real estate environment before making your first investment with your self-directed IRA.

Minimizing Investment Expenses In Your Self-Directed IRA

Self-directed IRAs are much more powerful than traditional retirement accounts. They allow the account holder to invest in the full range of investments permitted by the IRS (which include real estate, private companies, private debt, and even precious metals), rather than being limited to the standard range of “stocks, bonds and mutual funds” that would be permitted by a traditional custodian.

As you might expect, this additional opportunity and flexibility sometimes comes at a price. Think about two different types of investments you might hold outside of a retirement account; shares of stock in a publically traded company, and a piece of rental real estate. The only costs you’re likely to face with owning the shares of stock are the commissions when you buy and sell shares. Simply holding the stock won’t likely incur any expenses or fees, except perhaps for taxes on dividends you receive, and an account maintenance fee that you may already be subject to.

But holding a piece of real estate for investment purposes is a much different scenario. The property itself is likely to need physical maintenance and upkeep, and there are certain to be expenses connected with finding tenants. And you’ll face a property tax bill every year, even if you aren’t bringing in any rental income.

It’s the same case with different types of investments that you hold within a self-directed IRA. Here are a few important concepts to consider to minimize the investment expenses within your self-directed IRA.

Understand Your Costs Before Investing. You’ll do a much better job of minimizing your investing expenses if you have a better understanding of what they’re likely to be before you invest. If you’re considering a particular type of investment within your self-directed IRA, and you’ve previously made similar investments in non-retirement accounts, then use that experience to estimate what your expenses might be, and to help you identify ways to reduce them.

Shop Around. Even if you’ve determined that you want to make a specific type of investment (let’s say real estate), it can pay to shop around for another specific asset in the same class that might carry lower expenses. For example, rather than purchasing a single-family home that comes with sizable repair costs, you might instead look to buy a property with a similar investment profile but that’s likely to require fewer repairs.

Use a Professional. Believe it or not, managing certain types of investments within your self-directed IRA yourself might be more expensive than hiring someone to do it for you. This is especially the case where you’re unfamiliar with the particular type of investment. When you’re considering bringing in outside help, remember to take into account the fact that you cannot compensate yourself for any time you spend managing investments within your self-directed IRA, whereas you can use funds from within your account to pay for professional management services.

Finally, don’t get so focused on reducing expenses that you fail to consider promising investment opportunities. Ultimately you want to maximize the total return in your portfolio, so if you have to spend a little more in order to make a lot more, that should be a trade-off you’re willing to make.

Investing In Oil And Gas With Your Self-Directed IRA

When people think of the “alternative” investment types they can purchase with a self-directed IRA, they generally think of precious metals, real estate, private equity and private debt. (And let’s be clear, it’s probably unfair to think of these as “alternative” investments because they are fully authorized by the IRS regulations relating to IRAs.) Another asset class, and one that perhaps comes to mind as often, relates to the oil and gas industries.

Because oil and gas investments are less common, let’s discuss some of the basics for making those investments with a self-directed IRA.

Don’t Ignore the Learning Curve. Oil and gas investments are arguably one of the most complicated types of investment that you can make. Concepts of mineral interests, surface rights, working interests and royalty streams are not generally encountered with other investments.

Because many oil and gas investments are relatively illiquid, it’s absolutely essential that you do your due diligence on any potential investment, and fully understand the nature of the arrangement you may be participating in. As with any other investment, don’t rush into an oil and gas opportunity if you don’t fully understand all the relevant terms, provisions and risks.

Types of Oil and Gas Investments. There are a number of different ways to make investments in the oil and gas industries, including not only the commodities and futures contracts, but interests in the refining and drilling companies, as well as investing in land or mineral interests where drilling is taking place (or likely to take place in the future).

Other Energy Projects. Even though we’re focusing here on oil and gas investments, understand that other energy industry projects may provide you with similar opportunities. If you don’t find any suitable oil or gas projects to invest in, consider solar energy projects, wind energy, biofuel, or water energy projects as well.
The developments of just the past few years solidly demonstrate just how much potential there is for oil and gas activity within the United States. But you may also wish to consider other projects that may exist outside the United States.

Tax Considerations. Depending on the type of investment you’re considering, you should check whether there are tax incentives available for investments made with non-taxable funds. If so, and you have enough funds available in your taxable investment account, then you may wish to make the investment outside of your self-directed IRA in order to maximize your benefits. However, many of these tax breaks have expired as domestic development has boomed, so most potential investments may still be suitable for your self-directed IRA.

Also consult with an expert to understand how UBTI (Unrelated Business Taxable Income) might impact your investment. This concept (which can be an issue for self-directed IRA owners when they seek to use debt financing to make an investment – such as getting a mortgage for a real estate purchase) can result in an immediate tax bill for certain types of investments.

The key in all aspects of an oil or gas investment within your self-directed IRA is to do your homework.

Want to buy a foreclosed home with your self-directed IRA? Learn more

Do you want to buy a foreclosed home with your self-directed IRA? While many local real estate markets have improved significantly over the past several years, there are still many opportunities for investors who want to buy a foreclosed home or bank-owned property. As you might expect, the process for buying foreclosed properties is slightly different than that for buying properties from the open market. In addition, the process for buying any type of property with your self-directed IRA is also different. Here’s an overview of what you can expect if you’ve answered yes to the question: should I buy a foreclosed home with my self-directed IRA.

1. Set Up a Self-Directed IRA and Fund Your Account. The first step to buy a foreclosed home with your self-directed IRA is, of course, to set up and fund a self-directed IRA. Choose a custodian such as Quest Trust Company, which can provide comprehensive custodial services for a self-directed account, and for which you fully understand the fee structure.

2. Identify Your Real Estate Investment Goals. In order to buy a foreclosed home with your self-directed IRA, you need to identify the types of foreclosed home investments you are interested in. What are your goals when you decide to buy a foreclosed home? Are you investing in real estate in order to gain an income stream, in order to achieve long term capital gains, or both? Are you looking to take a distribution of the property once you retire, and live in it yourself? Determining your goals can help you narrow down your potential list, making it easier for you to buy a foreclosed home that meets your investment goals.

3. Identify Your Budget. How much do you currently have in your IRA, and how much do you plan to invest when you buy a foreclosed home? As you identify your budget, keep in mind that a foreclosed home will likely come with operating expenses that your self-directed IRA will be responsible for. These expenses must be met with assets from within your account, which can be either income generated from the foreclosed home itself (or from other assets within your account), liquidated assets from the account, or your annual account contributions. If you decide to buy a foreclosed home that has operating expenses, you cannot pay these expenses with your own personal funds outside of the IRA.

4. Secure Financing (if necessary). If your account balance is not large enough that you can’t pay cash when you buy a foreclosed home, your account will need to obtain financing for the purchase. Note that some banks that sell foreclosed homes may prefer (or perhaps require) a cash sale over one that’s financed. In addition, obtaining financing of this type could have adverse tax implications for your account. In general, an all-cash purchase is often the better choice when you buy a foreclosed home with your self-directed IRA.

5. Conduct Your Property Search. Only after the prior steps have been completed should you begin your quest to buy a foreclosed home. During this process, realize that foreclosed homes are often subject to a higher level of damage or disrepair due to the circumstances that brought the property back onto the market. It’s often helpful to obtain professional assistance in evaluating properties.

When you buy a foreclosed home with your self-directed IRA, you’ll often discover a very rewarding undertaking. Follow the guidelines above to put yourself in the best position to succeed.

Quest Trust Company helps change people’s lives and financial future through self-directed IRA investment education. Quest Trust Company helps people invest in what they know best and build their financial future on their own terms.

Checkbook IRA LLC Pros and Cons with Quincy Long Hosted by Cash Flow Depot (Teleconference)

A very popular idea in the self-directed IRA industry is to have what some have termed a “checkbook control” IRA. These have been under attack by the IRS. Click the link below to listen to Quest Trust Company President H. Quincy Long talk about the dangers of Checkbook Control IRA LLCs
Click Here To Listen

Want to Build IRA Wealth Fast? Know Your Options

By H. Quincy Long for the Self-Directed Source Blog

Have you wanted to buy real estate in your IRA but think you don’t have enough money? Think buying a small property for all cash is your only choice?

Nothing could be further from the truth.

You can invest in real estate using your IRA without a lot of money in several ways, including buying property with debt, partnering with other investors (IRA or non-IRA money), or even utilizing seller financing.  However, in this article we will discuss one of the most powerful and grossly underutilized tools in real estate investing today – the option.

 Option Basics and Motivation

Let’s focus on some option basics. First, what is an option? Once consideration for the option is paid, an option is the owner’s irrevocable offer to sell the property to a buyer under the terms of the option for a certain period of time. The buyer has the right but not the obligation to buy. The terms of the purchase are binding on the seller at the discretion of the buyer.

Why would an owner agree to tie up his property with an option? Advantages to a property owner are many, and include: 1) the owner may be able to time his income for tax purposes, since option fees are generally taxable when the option is either exercised or expires (always check with your tax advisor); 2) if the owner needs money (for taxes, for example), an option may be a way to get money that he doesn’t have to repay, unlike a loan; 3) options are very flexible, and the owner may be able to negotiate an option which allows him to keep the property until a more opportune time – this is especially true of an owner in a pre-foreclosure situation.

Paperwork is Everything!

Options are extremely powerful and very easy to mess up. Get the paperwork right up front! So what forms do you use? The answer is my favorite as a lawyer – it depends! There is not and cannot be a “standard” option for all purposes. They are simply too flexible. You must decide on a specific use for the option and then be very specific, clear and complete about all the details. Remember, with options, you have to negotiate for both the terms of the option and for the terms of the purchase of the property.

Crucial Terms to be Negotiated and Documented

With a well written option, there is a fairly length list of terms to be negotiated and documented in the contract, including:

a)      Who is granting the option? Does it include heirs, successors and assigns?

b)      Who is receiving the option? Does it include assignees of the buyer, or is it an exclusive option to purchase by the buyer only?

c)      What property is being optioned? Property can be anything, including real estate, a beneficial interest in a land trust, a real estate note or nearly anything else.

d)     What is the consideration for the option? Remember, there must be some consideration for the option in the form of money, services or other obligations.

e)      How is the option exercised by the buyer? This is one of the easiest things to mess up in an option. If the procedure is not clear for exercising the option, it is an invitation to litigation!

f)       What will be the purchase price of the property if the option is exercised?

g)      How will the purchase price be paid when the option is exercised? Will it be for cash? Seller financing? Subject to the owner’s existing mortgage?

h)      Will the option consideration be credited to the option price or not?

i)        When can the option be exercised? For example, does the option holder have the right to exercise the option at any time during the option period, or can the option only be exercised after a specified amount of time?

j)        When will the option expire, and under what circumstances? The option should have a definite termination date, but might also include other circumstances under which the option terminates, such as a default under a lease.

k)      When it comes time to close, what are each party’s obligations? For example, who pays for title insurance, closing costs, etc? Are taxes prorated?

Possible Outcomes

Five potential outcomes exist once an option is created.  They are:

Expiration. When you have negotiated and executed an option agreement for your IRA, the first of several choices is to let the option expire on its own terms. Sometimes this is the best course of action if the deal is not what you expected, especially if you only paid a small amount for the option. The consideration paid for the option is retained by the seller.

Extension. If closing within the originally agreed upon timeframe in neither possible or practical, but you still desire to exercise the option, you may wish to negotiate an extension, either by paying additional option consideration, changing the price, or altering some other terms.  Be sure to document this extension as carefully as you did the original option.

Exercise. Another choice is that your IRA could exercise the option and buy the property. Since there are ways to finance property being purchased by your IRA, including seller financing, bank financing, private party financing or even taking over property subject to a loan, this may be a good strategy for your IRA, even if the IRA does not have the cash to complete the purchase. Be aware that if your IRA owns debt financed property, either directly or indirectly through an LLC or partnership, its profits from that investment will be subject to Unrelated Business Income Tax (UBIT). This is not necessarily a bad way to build your retirement wealth, but it does require some understanding of the tax implications.

Assignment. A fourth choice is to assign your option to a third party for a fee. Your option agreement should specifically allow for an assignment to make sure that there are no problems with the property owner. This is a great technique for building a small IRA into a large IRA quickly. I had one client who put a contract on a burned house for $100 earnest money in his daughter’s Coverdell Education Savings Account, then sold his contract to a third party who specialized in repairing burned houses for $8,500. In under one month the account made a profit of 8,400%, and all parties were happy with the deal! The account holder then immediately took a TAX FREE distribution to pay for his daughter’s private school tuition.

Cancellation. A fifth choice that sometimes is overlooked but ideal in the context of self directed retirement accounts (for capital preservation) is the ability to release the option back to the property owner for a cancellation fee. In other words, this is a way for your IRA to get paid not to buy! Let me give you an example of how this might work. Suppose you want to offer the seller what he would consider to be a ridiculously low offer. When the seller balks, you say “I’ll tell you what. You sign this option agreement for my IRA to purchase this property at my price, and we’ll put in the option agreement that I cannot exercise my option for 30 days. If you find a buyer willing to offer you more money within that 30 day period, just reimburse my IRA the option fee plus a cancellation fee of $2,500.”  Either way, your IRA wins!

The creative use of options is one of the most powerful ways to make your IRA or 401K grow astronomically. If used correctly, options maximize the leverage of a small account and offer significant flexibility for the option holder.

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 proportionateto 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, Pay or 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.

But the best news of all is that we now have the Roth 401(k). Starting in 2006, if your plan allows it, you can defer part of your salary into a Roth 401(k). For 2007 and 2008, the maximum salary deferral into a Roth 401(k) plan is $15,500 ($20,500 if you are 50 or over). This doesn’t include the profit sharing contribution of the plan which can be up to 25% of the wages or net income from self-employment. Although the salary deferrals are post tax (meaning you still have to pay income, social security and Medicare taxes on the amount deferred into the plan), qualified distributions from the account are tax free forever. Unlike the Roth IRA, there is no maximum income restriction. Combining the power of an Quest self-directed Roth 401(k) and the real estate exception for 401(k) plans under IRC §514(c)(9) means you can use Other People’s Money to purchase real estate and NEVER PAY TAXES on the income and capital gains!

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. For 2005, the marginal tax rate for ordinary income above $9,750 was 35%. Capital gain income is taxed according to the usual rules for short term and long term capital gains. 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 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 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!”