3-Steps to Evaluate Investments for IRS Compliance

The beauty of a self-directed IRA or Solo 401(k) is that you can invest in a wide array of opportunities.  By being able to invest in what you know and understand, you can have greater control over the outcomes.

The trade-off for this flexibility and control is that you are tasked with navigating IRS rules as you choose and execute plan investments.  When you are in the walled garden of an IRA with a brokerage firm, there is not as much concern about rules because you really can’t break them.  Once you open up the possibilities and take more control, it is a different story.

While the IRS rules can be complex, and it is always important to have an experienced guide you can rely on, it is fairly simple to make a quick determination about the suitability of any particular strategy.  We have a three-step method we recommend.

1 – Are Disqualified Parties Involved?

The main compliance concern with a self-directed retirement plan is operating in a way that is exclusively for the benefit of the IRA or 401(k).  This means avoiding any self-dealing or interactions with disqualified persons to the IRA.

Disqualified persons include:

  • The IRA account holder
  • Their spouse if married
  • Lineal antecedents such as parents, grandparents, etc.
  • Lineal descendants such as children, grandchildren, etc.
  • The spouse of a descendant
  • A fiduciary or other person providing services to the plan
  • Certain key employees, partners, or joint venturers of an entity sponsoring a plan or controlled by a disqualified person.

Any action that creates a direct or indirect transaction or benefit between a plan and a disqualified person will result in a prohibited transaction and severe tax consequences.

Things to avoid include:

  • A sale, exchange, or transfer of value
  • Lending of money, extension of credit, or any co-mingling of funds
  • Furnishing of goods, services, or facilities
  • Transfer or use of plan assets or income produced by plan assets
  • Otherwise dealing in one’s own interest via the plan

With the above in mind, it is easy to determine if a planned investment will be within the rules.  If the transaction involves a disqualified person, simply don’t go there.

Of course, as the first person on the list of disqualified persons, you are not restricted from administering your IRA.  You can make decisions, execute contracts, fund transactions, and receive the income produced by investments.  You just need to do all these things on behalf of the IRA and in the IRA’s interest, not in ways that provide a current benefit to you.

2 – Active vs Passive Income

A common misconception held by those new to the self-directed IRA space is that all investments made with a retirement plan are fully tax-sheltered.  That is the way it works in the stock market, right?

In reality, there are certain types of activities that while allowable for an IRA will create a tax liability due to the nature of the income being produced.

An IRA or 401(k) is intended for passive investments.  Income from passive activities like interest, dividends, royalties, rent from real property, the sale of an asset held over time, and the like will be fully sheltered into the plan.

When a tax-exempt entity like a retirement plan acts like a business and is deemed to be substantively competing with tax-paying enterprises, that is a different matter.

If a self-directed IRA is used in a way that is viewed as a trade or business, and does so on a regular or repeated basis, the gains from those activities are classified as Unrelated Business Taxable Income (UBTI).  The IRA will then need to pay tax on the gains.  This tax is designed to level the playing field and protect businesses from unfair competition.

Common examples of activities that generate UBTI include:

  • Ownership in an operating business such as a restaurant, retail, or services company, if the entity is a pass-through for taxation. A business operating as a subchapter C corporation pays taxes on income and issues passive dividends to investors and will therefore not generate UBTI.
  • Any kind of flipping or dealer transaction such as buying and reselling real property, vehicles, or other personal property.
  • New home construction for immediate sale.
  • Services oriented real estate such as hotels, short term rentals, adult care, and self-storage.
  • High volume day-trading of securities.

Because an IRA is taxed at trust rates that can scale up to 37% quickly, caution should be exercised with opportunities that produce UBTI.

The mere presence of UBTI, however, is not always a deal-killer.  It just depends on what income will be impacted and how that affects the overall risk/return of the investment.  If the prize of an investment is operating income subject to UBIT, that may not produce a positive result unless the income is in excess of 25% returns.  If operating capital is ancillary to the real goal, such as a gain in equity when a company is sold or goes public, then the impact of UBTI may not be a concern.

3 – Use of Debt-Financing

When an IRA or 401(k) borrows money to make an investment, another form of taxable income known as Unrelated Debt-Financed Income (UDFI) is generated.

The most common examples are using non-recourse mortgage financing to purchase an income property, or participating in a larger real estate partnership or syndication that uses bank financing for property acquisition.

Other types of activities that can incorporate debt include leveraged private investment funds and margin trading in the stock market.

The concept around UDFI is that the portion of income a plan receives that is derived from the non-plan (borrowed) capital is taxable.

As an example, if your IRA were to purchase a rental property with a 40% down payment, the project is 60% debt financed.  That means that 60% of the income is deemed UDFI and subject to taxation.

The upside is that once an IRA or 401(k) has a tax liability, it can use allowable deductions to offset that income and reduce the tax burden.  As such, the net tax impact of mortgaged real estate investments is not typically significant once deductions for depreciation, interest on the note, and other allowable expenses are factored in.  Leverage creates a boost in return.  The tax on UDFI will put a small dent in that boost but will not negate the overall benefit of leverage.

The great news for real estate investors who qualify for a Solo 401(k) is that such plans have a specific exemption from tax on UDFI when the debt is used for the acquisition of real property.  Other non-real estate debt is still taxable, however.

The Other Important Consideration

Of course, just because an opportunity fits within the IRS rules, that does not automatically make it a good investment.  You want to be sure to evaluate the merits of the deal, the risks involved, potential liquidity, and other factors to make sure it is a good investment for your retirement plan.

Making a Final Determination

If a potential investment strategy is suitably at arm’s length, is unlevered, and produces passive earnings, that is three green lights and you can proceed with confidence.

Any direct or indirect intersection with disqualified persons is a significant concern.  You should exercise caution and consult with licensed professionals before proceeding.

When an investment has the potential to generate taxable UBTI or UFDI, additional research is required.  If the net after-tax returns of an opportunity are good, it can still be a suitable investment for your plan.

As always, make a plan, take your time, consult with professionals, and get it right.

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