Many real estate experts are starting to call the period dating back to late Spring of 2020 as “the great migration”. Shifts in how we work and what we value are changing where we want to live, and thousands of families are moving. Some want more space, some want a smaller community, and many are looking to reduce their housing cost now that work-from-home jobs mean they don’t need to be tied a big city location.
All this movement creates tremendous opportunity for savvy investors. Average home prices are up 13% nationally from May of 2020 to May of 2021 according to Zillow. Many markets like Austin, Phoenix and Tampa saw gains much higher than that.
When prices are rising this quickly, house flippers are normally busy. While flipping trends were strong in late 2020, they have slowed down in 2021 even though home prices continue to go up. That is a little unusual.
There are several likely reasons for this, namely stiff competition to buy and climbing costs of acquisition. It takes a lot of guts to buy in this kind of market and hope for a quick-turn profit. It also seems like a lot of investors are choosing to hold properties. Like home prices, rents are also increasing. If many predictions of another year of double-digit price gains are accurate, why not hold?
Flipping is not an IRA Friendly Strategy
As we have written on many occasions, house flipping is not particularly well suited to an IRA. The operation itself can tempt investors to be more hands-on than perhaps the IRS rules allow for. More importantly, income from flipping transactions executed on a regular or repeated basis can create taxable Unrelated Business Taxable Income (UBTI).
This tax occurs because flipping is a business, not a passive form of investment income. When a tax-exempt entity like a Self-Directed IRA or Solo 401(k) plan acts like a business and competes with tax-paying businesses, it is taxed on UBTI to level that playing field.
Because of the taxable nature of flipping, we have often encouraged alternative approaches that produce passive income not subject to UBTI.
Where Flip Profits Come From
Flip profits come from two key aspects of the transaction. The old adage. “You make money when you buy” certainly holds true, though it is harder to do that right now. If you can acquire a property at discount, you lock in profit if you can sell later at market value.
Even in a seller’s market like we are in currently, there are opportunities. You just need to have the patience to find the right deal or an avenue to generate below market opportunities like a relationship with a good wholesaler or expertise in auction sales.
The other way you make money on a flip is by adding value with the correct level of repairs and updates.
In a well-executed flip, you should be able to acquire and update a property with a net price per foot at least 20% below what it would cost to purchase a similar property in move-in condition.
When Your IRA Profits Makes All the Difference
There is no issue with using an IRA or 401(k) to purchase a property at discount and have it fixed up – so long as you or disqualified parties are not the ones doing the fixing part. While you can manage the affairs of your IRA without conflict, if you provide value to the IRA in the form of contracting services that becomes a self-dealing issue in violation of IRS rules.
Where a flip becomes less than optimal for an IRA is not the acquisition path, but rather the exit strategy. If your IRA purchased, rehabilitates, and then sells a property, that is considered a dealer activity. If done with any frequency, UBTI is generated and can result in taxes of up to 37%.
But what if your IRA does not sell immediately?
The whole nature of the transaction is reconfigured if property is held as a passive rental for at least 12 months. If in the future the property is then sold, this is not considered a flip or dealer transaction that generates UBTI. Now your self-directed retirement plan is simply disposing of an asset that has been held to produce passive income.
Bingo! Now your IRA can capture the full gain created by a smart acquisition and rehab, without giving up a big chunk to taxation. The gain on sale as well as any rents accumulated during the hold accrue to your IRA fully tax-sheltered.
Success in any real estate transaction is affected by local conditions and not national trendlines. No single strategy is ever the best play at any given time in every market.
In the markets that are experiencing population inflows, however, the hybrid flip can be a great way to position your IRA for profitability. As demand for homes to purchase and homes to rent increases, this strategy puts you in a win-win. You might even find the opportunity to have your IRA rent to someone who is testing the waters in a new location and is not ready to buy… this year.