A lot of investors learn about the potential of investing in real estate with a self-directed IRA, and immediately gravitate toward property flipping. There’s good reason for this, as a well-executed flip can be a very profitable venture and a great way to grow your retirement savings.
However, flipping in a self-directed IRA is complex. A thorough evaluation of the concept is required before running off to the next foreclosure auction with your newly established Checkbook IRA.
Flipping properties in an IRA is not as simple as finding a good deal on a distressed property, fixing it up, and selling it at a profit. The tax-sheltered nature of a self-directed IRA or Solo 401(k) comes with certain restrictions per IRS rules. These restrictions can be quite noticeable when trying to flip houses.
Once you understand the different paradigm in which an IRA or 401(k) operates, you can approach the opportunity of flipping strategically, and choose an approach that suits your goals while remaining in compliance with IRS guidelines.
Rule #1 – Hands Off
With a self-directed IRA, you have tremendous flexibility to invest in a wide variety of opportunities. You also have close control over what your IRA invests in, and the administration of the account.
However, what you always need to keep in mind is that IRS rules require all your IRA’s activities to be conducted exclusively for the benefit of your IRA. You can’t personally benefit from the IRA, nor may you provide benefit to the IRA via the provision of goods or services.
When it comes to investing in real estate flipping, this means you need to take a big step back from the actual flipping and act more like a fund manager.
Your services have value. If you gift those services to the IRA, it’s like making non-documented contributions to your IRA. IRS rules prohibit this, and a violation of those rules can be catastrophic to your IRA.
You can act in an oversight and administrative role. Identifying opportunities and negotiating purchases, coming up with a rehab plan, hiring vendors to do the work, and dealing with the expense and income transactions along the way are all acceptable.
You shouldn’t perform work on the property personally, as this would be a clear violation of IRS rules. You should also avoid becoming the delivery person for your contractors by making frequent runs to the hardware store. Any permits should be acquired by your hired contractors, and not by you.
For many investors who have experience in the contracting trades, these restrictions can be a deal killer. Making the jump from contractor to “investment manager” is not for everyone, but it is a requirement when your IRA is the investor.
Rule #2 – Unrelated Business Taxable Income
When your IRA invests in a stock and then sells the stock later for a profit, that transaction is fully tax sheltered. So the same concept applies when your IRA sells a property at profit, right? Not exactly.
An IRA or other tax-exempt entity receives tax-favored status when it receives income from passive sources. When a tax-exempt entity engages in a trade or business on a regular or repeated basis, however, then taxation on Unrelated Business Taxable Income (UBTI) applies.
This tax is designed to protect tax-paying businesses from unfair competition. When a tax-exempt entity generates UBTI, the resulting tax paid is referred to as Unrelated Business Income Tax (UBIT).
Holding a stock and selling it at some point in the future is a passive investment that’s fully tax sheltered. But buying houses, fixing them up, and then selling them isn’t considered passive — this is a real estate development activity.
As such, if your IRA flips houses on a regular or repeated basis, it will generate UBTI. The trust tax rates for UBTI ratchet up to 37% pretty quickly, and can put a real dent in the profitability of a flip transaction.
So what is “regular or repeated”? The answer is: “It depends, and the IRS gets to make the determination based on the facts and circumstances of a particular situation.”
The IRS rules are not so specific as to outline what frequency of property flips over what time-period will cross this threshold. Rather, the IRS has the flexibility to determine if a particular activity is substantially similar to commercial enterprises in the same field. If so, then your IRA’s flipping transactions may be exposed to UBIT.
What this means is that an occasional flip transaction, especially if mixed into an IRA portfolio that is also producing passive income, will likely not be considered a trade or business regularly engaged in. If all your IRA does is flip, and you’re also actively flipping homes outside your IRA, the threshold for UBTI exposure might be lower.
What makes the concept of UBTI even more challenging is that it’s your responsibility as the taxpayer to make the determination as to whether your IRA has tax liability and file accordingly. If you guess wrong and get audited, then there will be additional penalties for the failure to file and back taxes the IRA should have paid. It’s in the best interest of your IRA to take a conservative approach to the frequency of flip transactions.
Weighing the Options
With these IRS rules in mind, you need to take a look at your intended flipping strategy and determine if it’s realistic. For many investors just starting to evaluate a self-directed IRA, this can mean a significant adjustment in expectations.
I can’t tell you how many times in the last dozen years we’ve had an initial conversation with an investor who anticipates being the contractor for their IRA that will flip 3-5 houses per year – all tax free. That would be great, but it’s not possible within the IRS guidelines.
There are several approaches to flipping that work within the rules that apply to retirement plans. Determining which is best for you depends on your expertise, amount of capital available, and how involved you wish to be.
The simplest approach to flipping is based on limited frequency and limited engagement.
For many investors just wanting to diversify their portfolio and who see an opportunity to flip in a specific market, this is a viable strategy. A few different transaction structures fit into this methodology:
- Your IRA can provide 100% of the capital for acquisition and rehab, and you can act in a limited role as the project manager by choosing vendors and materials, and ensuring the project is run according to scope and timeline. At the time of sale, all profits will return to the IRA.
- Your IRA can partner with a contractor, with the IRA providing some or all of the capital. The contractor may only provide their services, or they may bring a mix of capital and services. The profits of the deal can then be split accordingly between the IRA and the contractor.
If your IRA has significant capital and there is real opportunity for profit with flips in your market, then an alternate approach we call a hybrid-flip may be an option that allows you to turn more deals.
Buying and fixing up a house is not what characterizes a real estate transaction as a flip. Immediately selling that fixed up property is what makes it a flip, and therefore a trade or business activity.
If your IRA fixes up a property and then holds that property as a passive rental for at least a year, then the future sale isn’t considered a flip, but rather just the disposal of a passively held asset — kind of like that stock mentioned earlier.
The profit potential of a flip comes from purchasing at a discount and adding value. If you can be patient about capturing that added value with a deferred sale, then the gain can be fully tax-sheltered within the IRA. The IRA may also benefit from the rental income over the holding period.
Taking a long time to rehab and sell the property will not achieve this goal. There has to be a rental usage for at least 12 months to make the property a passively held asset.
Many of our investors will directly flip one or two properties per year, then utilize the hybrid flip model to do more deals on the passive side of the ledger.
Being the Bank
Your IRA doesn’t necessarily need to be the flipper to generate solid income in a market where flip opportunities are available. Another great approach is to step back and have your IRA act as a private lender to other investors who are flipping houses.
This strategy is especially appealing for investors who may not have a lot of time or expertise with house flipping. The IRA can hold a mortgage secured by a property being flipped. The interest income received on the mortgage is passive income that isn’t classified as UBTI.
Volume Flipping with a UBIT Blocker
With the passage of the Tax Cuts and Jobs Act of 2017, another approach to flipping became viable. This strategy involves the use of a UBIT blocker corporation.
While this method doesn’t eliminate taxation on high frequency flipping, it reduces the tax rates significantly so it can make sense to flip inside the IRA.
An IRA with UBIT exposure will pay up to 37% tax based on federal trust tax rates. With the TJCA, the corporate tax rate was reduced from 35% to 21%. By investing the IRA into a taxable corporation that engages in flipping, the IRA can reduce the tax rate on flip profits from the 37% trust rate to the 21% corporate rate.
The flips take place in the corporation and the corporation then pays tax at 21%. After-tax profits can then either be retained in the corporation and deployed into additional flips, or issued as non-taxed dividends to the IRA shareholder.
The UBIT blocker doesn’t change the rules related to self-dealing. All activities of the IRA-owned corporation must be conducted at arms’ length, just as in any other IRA scenario.
This strategy only makes sense for those investors with the capacity to fund multiple flips per year. The cost of establishing and maintaining the corporation and filing corporate tax returns won’t be justifiable for a smaller portfolio.
Retirement Funded Development Corporation
The above strategies apply to a self-directed IRA or Solo 401(k) and fit within the arms’ length requirements of such plans. There’s an entirely different route that allows you to use existing retirement savings to capitalize your own business and invest in yourself — without taxes or penalties.
If you have experience in house flipping and want to be directly involved with flip projects, this Business Funding IRA — sometimes called a Rollover as Business Startup — can be a path to creating your own business and striking out on your own.
This alternative structure involves forming a sub-chapter C corporation as your active business. The corporation establishes a 401(k) retirement plan that you can then rollover existing IRA or 401(k) savings into.
The retirement plan then purchases shares of the parent corporation via an employee stock option purchase (ESOP). The retirement plan is now a shareholder of your business that you can use for real estate development.
While there are no taxes or penalties for using this self-funding method, the business itself will operate as a normal taxable entity. So there is a trade-off of access to capital at the expense of tax-sheltering of income.
However, if your business is profitable, you can still achieve sheltering benefit by issuing dividends to shareholders — which will be tax-deferred to the retirement plan, and by making new contributions to the plan.
As with the UBIT blocker, this more complex plan strategy is only beneficial if you have sufficient retirement capital to fund a business that can execute multiple transactions per year.
Which Path is Right for Your IRA?
We hope this brief overview has helped you gain a better understanding of how flipping houses fits within the special rules that apply to tax-sheltered retirement plans, and the different approaches that can be used to engage in flipping opportunities.
If you would like to learn more about how to best deploy your IRA into flipping, please feel free to contact us. One of our expert advisors will help you better understand your options.