Flipping houses can be a very profitable activity. As a result, we speak with many investors each month wanting to use a self-directed IRA or Solo 401(k) for flipping houses. Unfortunately, this strategy often becomes undesirable due to the potential for exposure to Unrelated Business Income Tax (UBIT).
UBIT is a trust tax that applies when a tax-exempt entity like an IRA regularly engages in a trade or business and is therefore competing with taxpaying businesses. The federal tax rate can get to be as high as 39.6%. That can really put a dent in the ROI your IRA may receive from a flip transaction.
With the recent tax law changes and the lowering of the federal corporate tax rate to 21%, there is now a better way to use IRA funds for flipping that can be much more profitable. This strategy involves the use of a blocker corporation.
Background – Understanding UBIT
As noted above, the main barrier to flipping houses in an IRA is exposure to UBIT. So what is UBIT? Exposure to Unrelated Business Income Tax occurs when a tax-exempt entity engages in a trade or business activity on a regular or repeated basis. Such trade or business activities include active real estate deals such as flipping, new construction for sale, and wholesaling properties. UBIT also applies when an IRA receives income (other than dividends from a taxable corporation) from a business such as a partnership or LLC that is providing a product or service. Certain activities that qualify as passive are exempted from UBIT, such as interest, dividends, royalties, rent from real property, or the sale of an asset that has been held over time to produce such passive income.
The purpose of UBIT is to level the playing field and protect tax-paying businesses from unfair competition stemming from tax-exempt entities that are substantively acting like a commercial business. If a tax-exempt entity like an IRA engages in what may be deemed as a business such as flipping a property only on an infrequent basis, it has not met the “regular or repeated” condition necessary and may not have exposure to UBIT. Unfortunately, there is no clear guidance from the IRS as to what in general would constitute “regular or repeated”, so the IRS has a lot of leeway to determine if the type and frequency of transactions cross that threshold and has UBIT exposure.
When UBIT applies, the IRA or 401(k) will need to file a form 990-T trust tax return to pay the necessary tax due. Trust tax rates apply, and are on a graduated scale, but they top out at 39.6% with $12,700 of net income after allowable deductions. Many states also have their own version of the tax that will apply as well.
The Impact of UBIT
The following example is an oversimplification, but illustrates the possible impact of UBIT on a flip transaction.
|Sales Price after Rehab||$200,000|
|Rehab & Holding Costs||-$50,000|
|After-Tax Net ROI||13%|
With this deal, your IRA made $22,282 on an investment of $150,000, for a net after-tax ROI of 13%. There are probably simpler and less risky means of generating 13% returns to the IRA such as private lending.
Strategies for Avoiding UBIT
In the past, there have been two primary strategies available to eliminate exposure to UBIT on home flipping opportunities.
Be the Bank: Have the IRA lend money to an unrelated 3rd party engaging in a flip. Such private or hard money loans generate interest income, which is passive in nature and therefore not subject to UBIT. The loan must be for fixed points and interest only, and may not serve as a means for the IRA to receive an equity stake in the profits of the flip. Generally, such loans might be for 1-3 points up front and 10-15% interest depending on the many factors such as how well you know the borrower, LTV, relative risk of the project, timeframe, etc.
Hybrid Flip: With this strategy, the IRA acquires a property at discount and adds value via rehab. Rather than immediately sell the property and have the transaction considered a trade or business, the property is then held and operated as a rental for a period of at least a year. In the future when the property is sold and the added value of the rehab is captured, this is not viewed as a flip/business and is therefore not subject to UBIT. This can be a very profitable approach simply by shifting focus and being patient, as the IRA will not only capture the equity gain in the value of the property in a fully tax-sheltered fashion, but also any net positive cash flow during the rental period.
While both of the above strategies work well within the envelope of a self-directed IRA or Solo 401(k), they are not really “flipping”, and do change the nature of the transaction.
Enter the UBIT Blocker
A UBIT Blocker is a taxable corporation inserted between a tax-exempt entity and a UBIT exposed transaction. The point of using such a vehicle is to lower the tax rate to the tax-exempt entity. Instead of the gains from a flip transaction being taxed at the higher 39.6% trust tax rates, normal corporate tax rates will apply. After tax-profits to the corporation can then be issued as tax-sheltered dividends to the underlying IRA or 401(k) plan. This strategy does not eliminate tax exposure, but can reduce the taxable rate. Such structures have been around for a long time, but, when the corporate tax rate was 35%, that really was not such a benefit for something like house flipping. Now that the top corporate tax rate has been lowered to 21%, there is a significant enough savings that the use of a blocker corporation may be beneficial for those investors wanting to flip houses or engage in other trade or business activities with their self-directed retirement plan.
Flipping with a UBIT Blocker
Let’s go ahead and take a look at our sample flip property and see how the numbers work out when using a UBIT Blocker Corporation.
|Sales Price after Rehab||$200,000|
|Rehab & Holding Costs||-$50,000|
|After-Tax Net ROI||18%|
By implementing the blocker strategy, the tax impact of the transaction was reduced by over $4,500. This results in an increased ROI of 18% compared to 13% in the prior case. If you then magnify this savings over several flip transactions during the course of a year, the difference can be considerable.
There are several ways a blocker structure can be configured with a Checkbook IRA LLC or Solo 401(k) plan. With the Checkbook IRA LLC platform, it may make sense to elect corporate tax treatment for the IRA-owned LLC itself if the sole purpose will be a business activity such as flipping. If flips will only be one of many strategies deployed, then forming a separate corporation under the umbrella of the IRA-owned LLC may make more sense. This would allow for passive investments in the master IRA-LLC while UBIT exposed activities would take place within the sub-entity. In a Solo 401(k) it will be necessary to form a separate corporation owned by the 401(k) for this purpose.
Please keep in mind that all investments of a self-directed IRA or Solo 401(k) must be conducted at arm’s length and exclusively for the benefit of the plan. While the use of a UBIT blocker changes the tax rates, all rules related to self-dealing will still apply. You or a disqualified party may not add value to the IRA or 401(k) via the provision of services. You may simply administer investments. That means leave your tool belt at home and ensure that all work on IRA owned properties is conducted by unrelated 3rd parties.
If you are interested in establishing a new self-directed IRA plan for flipping, or would like to discuss adding a blocker layer to your existing Safeguard provided plan, please feel free to contact us.