In the last post, you learned about how doing an active “entrepreneurship-ish” deal inside your IRA is an open invitation for the IRS to tax the hell out of you.

In this post, you’ll learn the solution.

• The solution is not to avoid doing active deals.
• The solution is not to stop pursuing massive profits or to lock away your talents and skill to be unused.

The solution is to structure both your active entrepreneurship and your passive investment activity in a way that that puts you in the most control. Put another way, avoid giving the IRS an open invitation to tax attack you.

I bet you can guess where this is going (one commenter had a pretty good idea on Part 1 of the post)…

Active Deal Structure

Run your active entrepreneurship activity (a.k.a. “business activity”) in your… (wait for it)… business! Your business can be a Sole Proprietorship or it can be more formally structured as an LLC or Corporation.

If your entrepreneurship needs a financial kickstart, borrow up to $50,000 (or $100,000 between you and your spouse) in the form of a “participant loan” from your pre-existing retirement funds. Do your business activity, generate massive profits, and contribute up to $54,500 (or $109,000 between you and your spouse) tax-deductibly each and every year. That adds up quickly.

Passive Deal Structure

Run your passive investments through your Self-Directed IRA or Solo 401k (a.k.a. your investment account).

My God, that sounds too simple to be effective, you may think. Hey now, don’t fall into the “scheming pit.”

Over 95% of the Self-Directed IRA conversations I see online are all about some sneaky structure to reign triumphant over the IRS, like a clever fox. Sounds like a good bubble to burst, so I don’t mind if I do…

The IRS doesn’t like being tricked. They can even be mean from time to time. I can’t help but to wonder how much profit would have been made if the millions of hours of sneaky scheming were to be replaced with taking action on making good investments with a non-risky tax approach.

Side Benefits

There are side benefits to this sound approach too.

Many Self-Directed IRA & Solo 401(k) investors are doing active real estate deals inside their retirement plan. That introduces further limitations, especially with debt financing, such as:

• Lower LTV (loan-to-value ratio) loan limits
• UDFI tax (if done inside an IRA) calculation, form preparation, and payment
• Less lenders and loans available in the marketplace
• Higher down payment (more cash investment required, which lowers cash-on-cash return)

Don’t get me wrong. Many healthy, profitable real estate deals are done inside retirement plans and with debt financing.

But, not all real estate deals should be done either inside or outside of a retirement plan. It depends on the circumstances.

If it’s truly a passive investment, go for it inside your plan. If it’s truly an active deal, go for it outside of your plan. If you want to pay cash or make a large down payment, that sounds fitting for inside your plan. If you want to invest as little cash as possible, that sounds fitting for outside your plan.

So, I hope this helps you get your mental strategery in order.

Like many lessons in life, the real progress is made in unlearning myths, deceptions, and bad information. I mean, it isn’t exactly earth shattering to stand up and say “Business activity goes in a business, and investment activity goes in an investment plan,” is it? Yet, after thousands of hours in the Self-Directed IRA industry, it may make a big impact.

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Odds & Ends:

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]]> http://www.jeffnabers.com/2010/11/16/the-most-elusive-dangerous-self-directed-ira-practice-part-2/feed/ 7 http://www.jeffnabers.com/2009/04/15/tax-return-for-ubit-does-your-retirement-plan-own-leveraged-real-estate-or-an-active-business/ http://www.jeffnabers.com/2009/04/15/tax-return-for-ubit-does-your-retirement-plan-own-leveraged-real-estate-or-an-active-business/#comments Wed, 15 Apr 2009 16:17:07 +0000 Jeff Nabers http://jeffnabers.com/?p=758 Just a quick, last-minute reminder…

• If your IRA owns mortgage-leveraged real estate, you owe UBIT.
• If your IRA or 401(k) owns an active business structured as a pass through entity (such as an LLC or partnership), you owe UBIT.
• If your 401(k) owns mortgage-leveraged real estate AND the mortgage is a “seller carry”, you owe UBIT.

UBIT, or Unrelated Business Income Tax, applies to tax exempt organizations including retirement plans. To pay UBIT, Form 990-T must be filed with the IRS. If this is all news to you, once you are done scolding yourself, you may want to file for an extension using Form 8868.

If you talk to the average CPA, he’ll tell you that UBIT is the boogeyman and is to be avoided… always. Discussing this topic with an above average CPA (such as Eric Wikstrom of Integrated Wealth Strategies) yields different advice.

The Two Types of UBIT

1. Triggered from a trade or business – if a tax exempt entity (such as an IRA or 401k) owns a trade or business, the income of that business is taxed at trust rates (i.e. very high tax rates). Both IRA & Solo 401k accounts are subject to this type of UBIT.
2. Triggered from ownership of leveraged real estate – if a tax exempt entity (including IRA) owns real estate leveraged with a mortgage loan, the portion of that income attributable to the mortgage loan is taxed at trust rates. This type of UBIT is specifically referred to as UDFI – Unrelated Debt Financed Income. Solo 401k accounts & other qualified plans are exempt from UDFI.

Trust tax rates are very high, so it might make sense to avoid Type 1 UBIT at all costs. On the other hand, a close examination of UDFI tends to revoke its “boogeyman” status.

The reason UDFI isn’t a detrimental cost is that non-recourse mortgage loans (the only type an IRA/401k can legally obtain) are typically only offered at a 65% loan-to-value maximum. So this means that the UDFI tax is only payable on up to 65% of the property’s net income. (That’s right – net income. You do get to deduct depreciation and other expenses before paying UDFI tax).

Let’s examine a simple comparison of the taxes payable on net real estate income with 50% leverage:

Example A

Example B

The gap between the dollar amount of taxes paid widens as the income increases:

Let’s go back and look at Example B. Take the difference in taxes and examine the long term effects of 25 years of investing and compounding returns. These charts assume a 15% annualized ROI:

Example B1

This uses an effective tax rate of 16.23% for UDFI

Example B2

This uses an individual tax rate of 28%

The result? The IRA has a balance of $631,385.87 more than the individual does.

Conclusion

It might make sense to avoid Type 1 UBIT, while Type 2 UBIT (UDFI tax) results in less taxation than the alternative of investing with individual funds.

5500-EZ for Solo 401(k) plans

If your Solo 401(k) plan assets exceeded $250,000 in value in 2007, a 5500-EZ must be filed by July 30, 2008. This is an informational return used to report plan value to the IRS and does not require any tax payment.

990-T for IRAs with mortgage financed real estate

If your IRA owns mortgage leveraged real estate, a form 990-T should have been filed with UBIT payment by April 15, 2008. Unrelated Business Income Tax is one an IRA must pay on the portion of income or gains attributable to the mortgage leverage used. For example, if your IRA owned a property with a 50% debt to basis ratio, then 50% of its income would be taxable at trust rates. While many investors balk at the idea of paying taxes on IRA profits, a tax analysis in most scenarios typically favors paying UBIT over making the same investment with non-retirement funds.