Updated 1/25/2019 (TJCA tax rate changes)
In our Real Estate 201 introductory blog, we looked at the basics of flipping property as a viable investment strategy for your self-directed IRA or 401(k) plan, and indicated the three primary options for how to do this. This time, we will take a closer look at the first option: using your self-directed IRA to flip real estate.
The Pros and Cons
The first thing you should do when choosing an investment strategy is to weigh its pros and cons in conjunction with what you are willing to undertake and what you wish to achieve. As with any investment strategy, there are specific benefits and drawbacks associated with using your self-directed retirement plan to flip property. For example, one of the most attractive aspects of this method is the direct stake it gives you in a project that has a potential for high returns. Naturally, this elevated potential for gain comes with its corresponding risk, and you should make certain that you are willing to undertake the potential risk, as well as the commitment of time and effort that finding, vetting, and administering such investments requires. It is important to ensure that you are fully apprised of what you can expect and all the requirements involved before embarking your capital on such a project.
In our introductory blog, we discussed the arm’s-length requirements for flipping property with your self-directed retirement plan. You will be deploying your IRA or 401(k) capital into the project and should think of yourself as a fund manager – not a flipper. You can oversee and administer activities, but you cannot be actively running a flip project on a hands-on basis. This is because such activity could be viewed as providing services to the plan, and therefore would constitute self-dealing, which is a prohibited transaction. Due to this requirement, you will typically want to work with a partner or with a hired contractor or project manager when you use your plan to flip property.
In our previous blog, we touched on the potential UBIT liability associated with using your IRA or 401(k) to flip property, and outlined how to determine whether it will apply to your investment. Now we will get into the specifics. Let’s start with the terminology used, which can sometimes be confusing. When a tax-exempt entity engages in a trade or business on a regular or repeated basis, it generates Unrelated Business Taxable Income (UBTI).The tax on this income is referred to as Unrelated Business Income Tax (UBIT).
If your investment generates UBTI, the rates can be as high as 37 percent of the net profits on a transaction, depending on the level of income produced during the year. While this rate of taxation may seem daunting at first blush, it can still leave you with quite a healthy ROI for your efforts.
How it Works
Let’s say you have invested a total of $150,000 into a project, including acquisition, rehabilitation, holding, and sales costs; and you are then able to sell the property for $200,000. Assuming an 8% cost of sales between realtor fees and title, the net gain of $34,000 is what will be taxed. The cost of UBIT on this income would be about $11,000. This would leave your plan with a net return of $23,000, which represents a 15 percent ROI.
If you conducted two such transactions in one year (ignoring, for simplicity, other factors such as re-investing the proceeds from the first deal into something else for 6 months), you would produce, after taxes, gains for your IRA in the amount of $46,000 (or 30.6 percent ROI) on the $150,000 invested. The net ROI numbers are really what matter when looking at transactions that have exposure to UBIT. When you compare the ROI of this type of project with that of others into which you could invest your IRA or 401(k), 30.6 percent is an excellent result, regardless of the taxes paid on the way to achieving it.
As we said, the most important thing is that you are certain about what you are willing to undertake when you are seeking to invest with your self-directed retirement plan, and if UBIT is a deal breaker for you, another option may be a better fit. In our next blog, Real Estate Flipping 201: Be the Bank, we will discuss the ins and outs of investing in property flipping as a lender with no-equity stake (which shields you from UBIT), so be sure to stay tuned.