By: Mat Sorensen, Partner at KKOS Lawyers and Best-Selling Author of The Self-Directed IRA Handbook
The most common asset class for self-directed IRA accounts is real estate. Real estate investments for self-directed IRAs come in various forms from simple single-family rentals owned 100% by the IRA to LLC or LP investment partnerships with multiple investors in larger commercial or multi-family properties.
Given the changes in federal securities laws that now allow investment sponsors and real estate syndicators to raise capital more easily, many self-directed IRA investors have considered investing their IRAs into these offerings. Numerous Crowdfunding sites are already offering Crowdfunding type investment opportunities for investors under SEC Rule 506(c). This rule and those investments are currently only available to accredited investors and have no restriction on the investment amount that may come from the accredited investor. These offerings have traditionally been known as private placements or “PPMs” but under the new laws these deals can now be marketed and there is no requirement that they be “private” so long as the offering company only accepts accredited investors.
For those who are not accredited investors, “true” Crowdfunding under Title III of the JOBS Act goes into effect in May of 2016. Under these Crowdfunding offerings everyone will be able to invest into Crowdfunding opportunities and the investment amount will be based on the investor’s income and assets. These new Crowdfunding rules were enacted in Title III of the JOBS Act and were put into final regulations by the SEC in late 2015.
Before investing your self-directed IRA into a real estate Crowdfunding offering, you must first learn and understand one very important tax called UBIT tax that may apply to your self-directed IRA’s income.
Will My IRA Be Subject to UBIT Tax?
Unrelated Business Income Tax (“UBIT”) applies to an IRA that receives non-passive income. UBIT is a hefty tax and has a maximum rate of 39.6%. IRC § 511. The hefty tax table is copied below.
2016 UBIT Tax Rates
Although not shown on the table, the first $1,000 in UBIT gross income is exempt and you receive an automatic $1,000 deduction.
UBIT will apply to your self-directed IRAs real estate investment in two scenarios. First, it will apply if the income to the IRA is ordinary. And second, it will apply if the offering company uses debt to acquire its properties.
Does UBIT Apply, Step 1: Is the income passive?
First, UBIT will apply if the investment is an ordinary income producing business. An ordinary income business in real estate investing would include investing into an LLC or LP that conducts new construction, real estate development property held for sale, or other activities that are deemed active business activities. Passive income investments, on the other hand, are specifically exempt from UBIT and include real estate rental income, capital gain income, interest income, and dividend income from a c-corp. IRC § 512(b). The vast majority of real estate Crowdfunding offerings are structured to obtain passive income such as rental income while the property is held and capital gain income when the property is sold. Typical real estate offerings where UBIT can be due include offerings to fix and flip properties or offerings for new construction or real estate development where the investment strategy is to buy properties to then immediately sale.
If you have an investment offering that is ordinary income (e.g. a fix and flip fund), then the income to the IRA from the fund will be subject to UBIT tax and the IRA will be required to file and pay the tax each year by using IRS Form 990-T. This responsibility to file the return each year is on the IRA account owner and not the investment sponsor or the IRA custodian so IRA owners need to know for themselves whether the IRA is subject to UBIT or not.
So for example, let’s say that a self-directed IRA invested into a Crowdfunding offering that was a real estate development with properties held immediately for sale and that the income was ordinary income. Let’s further assume that the self-directed IRA received a K-1 for profits to the IRA for the year of $10,000. Based on the UBIT tax table, the IRA would owe UBIT tax in the amount of $2,420. This amount is due from the IRA to the IRS and is reported and payable using form 990-T.
If you’ve determined that the Crowdfunding offering income is passive (e.g. rental, capital gain), then you may still be subject to UBIT if the LLC or LP offering company is using debt to leverage and acquire its properties.
Does UBIT apply, Step 2: Will the investment be leveraged with debt?
Second, UBIT will apply to profits returned to your IRA from a Crowdfunding real estate offering (and really any real estate owned by your IRA) if the offering company uses debt to leverage its acquisition of properties. For example, let’s say the offering company raises $1M in cash to buy a $4M multi-family property. There will be $1M of cash invested into the property and $3M of debt. The property will therefore be leveraged 75% with debt.
Whenever an IRA’s investment is leveraged with debt, the tax code requires the IRA owner to determine what profits are attributable to the IRAs cash and what profits are attributable to the debt. The profits attributable to the cash invested are treated as tax deferred (traditional IRA) or tax free income (roth IRA) and are not subject to UBIT. The profits and income attributable to the debt, however, is called unrelated debt financed income (“UDFI”) and is subject to UBIT. IRC § 514. So, in the multi-family property example above where the property is leveraged 75% with debt, the self-directed IRA will have UDFI income on 75% of its income or gains.
The good news is that the IRA is also allowed to take expenses against the property using the same leverage ratio (e.g. 75%) and is also able to take depreciation expense. The property expenses and depreciation help to minimize and sometimes offset UDFI altogether.
So, in short, a self-directed IRA owner should consider two issues before investing into an LLC or LP real estate investment offering. First, is the offering company’s income passive or is it ordinary. If it is ordinary then it is subject to UBIT. If it is passive, then it is only subject to UBIT if the company uses debt to leverage its real estate investments.
Simplified Real Estate Investment Structures
The rental real estate market has been accustomed to leverage and many real estate investors will leverage their investment purchasing power with the use of a mortgage or other debt. While this can be a good strategy, I’ve noticed a trend in real estate offerings and deal structures that are being accomplished with no debt.
This is occurring for numerous business reasons but regardless of the reasoning, it is one that certainly simplifies the process for a self-directed IRA investors as they no longer need to be concerned with UBIT and UDFI tax. In fact, most self-directed IRA investors who buy real estate directly with their own IRA will simply buy them with the cash in their account and this certainly simplifies their reporting and their IRAs tax obligation. These properties may include single-family rentals or smaller commercial or multi-family properties acquired by the IRA investor with the cash in their own account.
In the crowdfunding and real estate syndication business, I am seeing a growth in deals being structured with no debt. Consider TripleNetZeroDebt.com, this company has small to medium sized commercial real estate offerings for accredited investors. All offerings by the company are for buy-and-hold triple-net commercial real estate and they do not obtain a mortgage or any debt to acquire their properties. Their properties are acquired entirely with investor and company cash. This deal structure creates simplicity and for self-directed IRA investors as they no longer need to be concerned or subject to UBIT or UDFI tax.
TripleNetZeroDebt.com has seen increased interest from Self-Directed IRA investors who like to invest in real estate but who want simplicity for their IRA (e.g. no UBIT/UDFI).
Jason Schwetz, founder of TripleNetZeroDebt.com’s properties says that they designed their real estate offerings with no debt for business purposes. The primary reason was because the company wanted its investors to be free from bank controls or restrictions in the event of vacancy or other unforeseen circumstances. They also saw lost revenue opportunity from covering the debt-service on the property.
A recent example of TripleNetZeroDebt’s offerings included two single tenant triple net properties occupied by Papa John’s in Indiana. The offering is currently paying a 6.44% annual cash-on-cash return that is paid monthly. The cash-on-cash return does not factor in any sales proceeds or returns from appreciation of the property. The company raised $659,000 to acquire the two properties and to establish a reserve fund. Again, no mortgage or debt was obtained.
The no-debt real estate structure has attracted many real estate investors who agree with the company’s no-debt philosophy. Self-directed IRA investors are starting to gravitate to such offerings and structures as the no-debt offerings keep the self-directed IRA investor out of UBIT/UDFI tax.