In many ways, real estate can be an extremely tax-favored asset class, as it can offer many tax-reducing avenues that will oftentimes have an immediate effect on your income tax burden. So, when real estate is purchased within an IRA account, the tax related advantages can increase even further.
In order to take full advantage of the added tax benefits that this type of investing can provide, though, it is important to have a good understanding of what is and isn’t allowed, as well as knowing other IRS-related rules that could have an effect on your investments and your IRA account(s) – and in turn, even on your overall retirement lifestyle in the future.
While a self-directed IRA account can offer a number of key tax advantages, it is important to understand just exactly where and when it may still be necessary to pay various tax liabilities per the IRS.
For example, throughout the time that you are investing – and provided that you leave funds in your IRA account – the money in the account is allowed to grow tax-deferred (with a traditional IRA account), or even tax-free (with a Roth IRA account).
So, in the case of a Roth self-directed IRA, the withdrawals that you take from the account will not be subject to taxation in the future. (This is the case, provided that you withdraw the money after you reach age 59 1/2. Otherwise, if you are under this age, you could be subject to an “early withdrawal” penalty by the IRS of 10% of the amount that is withdrawn).
If, however, you are investing in a self-directed traditional IRA account, even though your tax liability will be postponed, you will still need to pay income tax on the money that is withdrawn in the future.
The amount of tax that you owe will be based on your income tax rate at the time you make the withdrawals. It is important to note here that, even though many financial advisors feel that your income tax rate will be lower in retirement, this is not necessarily always the case – especially if your investments and / or other income sources in retirement are the same, or even more, than the income you earned during your working years. Your income tax rate can also be affected by the way in which you file your taxes (i.e., for example, as a single individual, as married filing jointly, or as married filing separately).
Just like with the Roth IRA, you could also be subject to an IRS early withdrawal penalty of 10% (over and above any other tax you owe), if you take funds out of a traditional IRA account before you reach age 59 1/2.
And, if you were allowed to defer your contributions into the traditional IRA (i.e., you were able to avoid paying income tax on the amount that you contributed in given years), then 100% of the amount that you take out of the traditional IRA will be subject to income tax.
Yet, even with a potential future income tax liability, though, the fact that a traditional IRA allows the tax-deferral of gains, it could mean that your investments were able to grow and compound exponentially – especially if you invested in the IRA account over a long period of time.
For many real estate buyers and investors, the use of debt is quite common in order to fund the transaction. In fact, depending on how the purchase is funded, as well as the type and amount of debt that is used, how you set up the funding for your real estate transactions can have a lot to do with how profitable a piece of property ultimately will be.
When using debt to fund your self-directed IRA real estate transactions, though, it is essential to understand that there are some ways in which the debt that is inside of an IRA account could end up diminishing you tax advantages.
For instance, while the law does not prohibit a self-directed IRA account holder from borrowing money, doing so could open up the IRA account to certain tax-related liabilities. This is because the IRS categorizes the income that results from debt in an IRA as “business income,” rather than income from investments.
If this ends up being the case, your IRA account may be liable for unrelated business income tax, or UBIT. According to the United States Internal Revenue Code, “for most organizations, an activity is an unrelated business (and therefore will be subject to unrelated business income tax) if it meets three requirements:
- It is a trade or business
- It is regularly carried on, and
- It is not substantially related to furthering the exempt purpose of the
Unrelated Business Income Tax is actually a unique tax that was created by Congress, and that is designed to apply not only to tax-exempt entities such as churches and charities, but also to retirement accounts under certain circumstances.
The reason behind the creation of UBIT was initially to alleviate unfair competition by exempt entities and organizations with taxable businesses. For instance, when considering a self-directed IRA account, if the IRA was to purchase a business, but it did not have to pay any taxes, then the IRA would essentially be able to deliver the same product or service, but at a discount.
This same set of rules also applies to an IRA’s investment in real estate when there is debt incurred for purchasing the property. Therefore, UBIT eliminates that risk for the regular (non-IRA) business owner and investor.
With regard to self-directed IRA accounts, there are actually two sources of unrelated business taxable income. The first one is when an investor invests his or her self-directed IRA funds into an existing business.
In this case, the portion of the business’s income that did not come from the IRA purchase may be considered as unrelated business taxable income – and therefore, subject to unrelated business income tax.
The other source of unrelated business taxable income can occur when a self-directed IRA investor uses debt to finance real estate via the IRA account. In this case, the portion of the property purchase that is attributable to the IRA would be considered tax-advantaged. The other portion that is financed through debt, however, could be subject to UBIT.
Just as with any other endeavor, complying with the IRS codes and rules with regard to self-directed IRAs is essential to ensuring that your account will be able to maintain its tax-advantaged status going forward.
In doing so, there are several key areas where the Internal Revenue Service has a say in whether or not your self-directed IRA account will be able to maintain its tax-advantaged status, based on whether or not the rules are followed.
Some of the most prominent of these include:
- Prohibited Transactions
- Disqualified Persons
- Self-Dealing / Personal Involvement
According to the Internal Revenue Service, a prohibited transaction is defined as being “any improper use of the IRA account by you, your beneficiary, and / or any disqualified person.” As previously discussed, a disqualified person includes yourself as the IRA owner, as well as the following individuals and entities:
- Your spouse
- Your ancestors and lineal descendents (such as your children and grandchildren)
- Your ascendants (such as your parents and grandparents, as well as your spouse’s parents and grandparents)
- Spouses of your lineal descendants
- Any investment manager and / or advisors for the self-directed IRA account
- Anyone providing services to the IRA, such as the trustee or custodian
- Any corporation, partnership, trust, and / or estate in which you own a 50% or greater interest
Self-directed IRA account holders must also be careful not to engage in what the IRS considers to be self-dealing. This means that all of the transactions that take place with regard to the account must be made at “arm’s length,” and they must not involve the IRA owner – or a member of his or her family.
With that in mind, a prohibited transaction that take place with regard to a self-directed IRA account can include the following:
- A transfer of plan income or assets to, or use of them by or for the benefit of, a disqualified person;
- Any act of a fiduciary by which plan income or assets are used for his or her own interest;
- The receipt of consideration by a fiduciary for his or her own account from any party dealing with the plan in a transaction that involves plan income or assets;
- The sale, exchange, or lease of property between a plan and a disqualified person;
- Lending money or extending credit between a plan and a disqualified person; and
- Furnishing goods, services, or facilities between a plan and a disqualified person.
Likewise, there are also certain types of assets that are not allowed to be purchased for a self-directed IRA (or any IRA account). These include collectibles, such as art, antiques, gems, coins, or alcoholic beverages – and certain precious metals may only be included if they meet specific requirements. Individual retirement accounts are also not permitted to invest in life insurance.
Based on Internal Revenue Service rules, if a disqualified person takes part in a prohibited transaction within an IRA account, then the transaction must be corrected. In addition, there will be an excise tax levied by the IRS which will be based on the amount that is involved in that transaction.
In this case, the initial tax on a prohibited transaction is 15% of the amount involved for each year (or part of a year) in the taxable period. If the transaction is not corrected within the taxable period, then an additional tax of 100% of the amount involved will be imposed.
Both of these taxes are payable by any disqualified person who participated in the transaction – other than a fiduciary who is acting only as such. Therefore, if there is more than one disqualified person who takes part in the transaction, then each of these individuals may be jointly and severally liable for the entire amount of the tax.
The amount that is considered to be involved in a prohibited transaction will be the greater of the following amounts:
- The money and fair market value of any property given; and
- The money and fair market value of any property received.
If services are performed, then the amount that is involved will be considered any excess compensation that is given or received.
With regard to the taxable period, this is considered to have started on the date of the transaction, and it ends on the earliest of the following:
- The day that the IRS mails a notice of deficiency for the tax;
- The day that the IRS assesses the tax; and
- The day that the correction of the transaction is completed.
In order to correct a prohibited transaction that took place with regard to an IRA account, the IRS mandates that “the transaction must be undone as much as possible, without putting the plan in a worse financial position than if the disqualified person had acted under the highest fiduciary standards.
If a prohibited transaction is not corrected during the taxable period, then the disqualified person will typically have an additional 90 days after the day the IRS mails a notice of deficiency for the 100% tax to get correct it.
This “correction” period – which encompasses the taxable period, plus the additional 90 days – may be extended, provided that either of the following occurs:
- The IRS grants reasonable time that is needed in order to get the transaction corrected; or
- The disqualified person petitions the Tax Court.
Therefore, if the transaction has been corrected within this period of time, then the Internal Revenue Service will abate, credit, or refund the 100% tax.
With this in mind, it is important to ensure that prohibited transactions do not take place within a self-directed IRA, and that disqualified persons are not involved in use of the account’s assets for personal use.
However, provided that all of the rules and regulations are followed, these types of accounts can offer a way to enhance the return on your retirement assets – particularly in light of the potential tax-related benefits.
Self-directed IRA account holders need to be aware of unrelated business income tax, or UBIT, as they could be liable for paying these taxes in certain situations. UBIT can be particularly relevant when an activity is considered to be an “unrelated business” per the account.
State when an activity is considered to be an unrelated business, according to the IRS, and will therefore be subject to unrelated business income tax:
According to the United States Internal Revenue Code, “for most organizations, an activity is an unrelated business (and therefore will be subject to unrelated business income tax) if it meets three requirements:
- It is a trade or business
- It is regularly carried on, and
- It is not substantially related to furthering the exempt purpose of the organization.