During the last few years, investing in crowdfunding opportunities has become a popular way for self-directed IRA and Solo 401(k) holders to put money to work. The concept of crowdfunding – or raising capital for a venture by securing small amounts of capital from a large number of investors – has been around for a long time. With the passage of the JOBS act in 2011, and final SEC rules effective in early 2016, it became much easier for businesses to solicit such investments from the public. There are now hundreds of platforms offering such investments.
Crowdfunding ventures come in many varieties; from capitalizing startups to peer-to-peer lending to real estate development projects.
There are many advantages to this kind of investing that make it appealing, including:
- Ability to invest with small amounts of capital
- Potential for consistent, solid returns
- Easy to manage
- Risk mitigation through diversification
- Leveraging the expertise of professionals
If you are thinking about investing your self-directed IRA or Solo 401(k) into some form of crowdfunding, there are a handful of things you need to know to ensure a compliant, tax-favorable project.
What Types of Funds are Suitable?
There are 3 basic types of crowdfunding: donation, reward and equity.
In a donation fund, a venture typically seeks small amounts of capital with no promise of return to the investor. This type of fund is not suitable for an IRA investor.
Reward funds typically promise investors a copy of the product the venture will produce, or some form of coupon/discount and early access to the product. Since your IRA does not have a need for a cooler with a built-in stereo and blender, or some other tangible item, this type of crowdfund is also not a good fit for retirement plan investors.
With equity based funds, investors are provided with a share of ownership in the funded venture. This is really the only type of fund that makes sense for IRA investors.
Are You Eligible to Invest?
While the securities associated rules have been relaxed in recent years, there are still limitations on the types of ventures that may seek crowd funding, where they can operate, and the types of investors they can accept.
There are also limitations on the amount of capital an individual can invest based on their income and net worth. An individual with annual income or net worth less than $100,000 may only invest up to the greater of $2,000 or 5% of the lesser of their annual income or net worth. Investors with net worth or annual income of more than $100,000 may invest up to 10% of the lesser of their annual income or net worth.
Because of these lower dollar thresholds, many crowd funds are only available to accredited investors with annual income over $200,000 ($300,000 if married) or with a net worth in excess of $1,000,000. If you are not an accredited investor, then one of the first things you will want to learn about a potential fund is whether it is open to non-accredited investors. Your IRA or Solo 401(k) inherits your personal limits when it comes to these thresholds.
Is There Exposure to UBIT Tax?
For IRA and 401(k) investors, ensuring that a planned investment will be fully tax sheltered is a key part of researching any potential crowd fund. Depending on how a fund is structured and what kind of income is produced, your self-directed plan could have exposure to Unrelated Business Income Tax. This tax exposure exists when a tax-exempt entity receives trade or business income.
Determining whether there may be UBIT implications can be complicated as there are many variables. If a funded venture is a C-Corporation and investors own shares and received dividends, this is passive income not subject to taxation. If a funded venture is a pass-through entity such as a LLP or LLC, and the income it produces is from providing a product or service, then an IRA investor could have exposure to UBIT on the operating income received from such a fund. However, any gain in value of the IRA’s shares in the venture would not be taxed. So, for a true venture capital play where the prize is not the income earned during start-up but rather the potential gain in share valve if the venture succeeds, then such an investment can make sense – even if there is some minimal exposure to UBIT. If the operating income produced by the venture is the real value of the investment, then UBIT can spoil the party for self-directed IRA investors.
The nature of the income produced by the venture also has an impact on whether the gains may be taxable to an IRA investor. If the venture is producing passive income such as interest from lending or rent from real property, then the share of income received by the IRA or 401(k) would not be subject to UBIT. UBIT only applies to trade or business income such as providing a product or service. In the real estate space, developing property for sale or rehabbing and promptly reselling properties are considered trade or business income. As such, when looking at real estate crowd funding, those that are providing loans to real estate developers, or that are holding properties long term for rental income and potential appreciation are generally going to be the best fit.
Is There Exposure to UDFI Tax?
Unrelated Debt-Financed Income is another form of taxable income in the IRA world. If an investment is using debt in addition to investor capital, then the percentage of income an IRA investor receives that can be attributed to that debt is taxable. So, if a fund is using investor capital for 25% of its capital and obtaining a loan for 75%, then 75% of the income an IRA receives (reduced by 75% of any applicable deductions) would be subject to UDFI taxation. A Solo 401(k) is exempted from UDFI taxation when the debt is used for the purchase of real property, but other forms of debt will create UDFI exposure for such plans.
When it comes to tax exposure, you should ask these questions of the fund sponsor. In our opinion, if they cannot give you a clear, precise answer on the topic, then they are likely not sophisticated enough to merit your investment. Of course, you should never simply trust the word of an investment provider, and should always consult with your licensed tax advisor to ensure an investment will be tax-favorable for your self-directed plan.
Be Informed for Success
As with any investment you might make with your self-directed IRA, knowing the right questions to ask is the first step towards success. The crowdfunding space is no different than direct investments in real estate, venture capital, or private lending in this regard. Be sure to perform thorough diligence of any investment you are considering and consult with your team of experts for guidance when it comes to matters of IRS compliance. If you operate from a place of knowledge, you can choose the investments that are best suited to your investment goals and potentially see solid growth in your self-directed IRA or 401(k) as a result.