Investing in real estate is a great way to diversify your tax-sheltered retirement savings. Most real estate opportunities provide a very different asset profile from conventional investments that can help you to build a more resilient portfolio. Real estate is not subject to the same types of news-driven volatility as stocks and provides income both through cash flow and the potential for appreciation.
With all these benefits, real estate is a very popular form of retirement investing.
Not all real estate investment types are well suited to an IRA or 401(k) plan, however, and choosing the right types of deals to grow your savings is important.
Some types of investments are classified as trade or business activities. When a tax-exempt entity like a retirement plan receives such trade or business income, it can be subject to taxation on Unrelated Business Taxable Income (UBTI).
While we have written many articles over the years on various implications of UBTI, we realized we have not provided a simple outline of the specific types of investments that trigger this type of taxation.
Starting with… What does not Create UBTI?
Most real estate investments create passive income. Such passive income is fully sheltered to a tax-exempt retirement plan. Examples of passive activities that do not generate UBTI include:
- Rental income
- Interest income
- The eventual sale of a property held over time to produce passive income
- Long term holds for appreciation (such as land)
- Royalty income (such as mineral rights)
Rental income, for example, is passive in most all transaction types. Whether the property is a single-family home, a commercial warehouse, or ranch land does not matter. Similarly, whether the IRA owns the property directly or via participation in a partnership entity like a LLC or LLP, the nature of the income produced is still passive.
Fixing and flipping houses is a very popular strategy. So is land flipping. Unfortunately, these are activities that create UBTI. The tax impact on returns from flips can often be a deal-killer.
Flipping is not a form of passive income. This type of transaction is more along the lines of a dealer activity or a development business. In the non-retirement world, flipping does not create passive capital gains, but rather generates earned income. When translated to the IRA world, that means trade or business income subject to UBTI when conducted on a regular or repeated basis.
So, what is “regular or repeated”? It depends, as we discussed in this prior article. There is no hard and fast rule, and the IRS would get to decide based on their interpretation of the facts and circumstances. We take the conservative approach that more than one such transaction per year may create UBTI exposure.
With flipping, there are a few good alternative approaches that work well for retirement investors.
Your IRA or 401(k) can be the bank and act as a lender to other flippers, so long as you do not lend in a way that creates a transaction with a disqualified person. The resulting interest income is passive and therefore does not generate UBTI.
Another option is what we describe as a hybrid flip. This strategy is the same as a flip on the front end, with the purchase and rehab of a property to add value. However, rather than immediately sell and create a dealer transaction with potential UBTI, the IRA holds the property as a passive rental for at least a year. In the future when the property is sold, that is not considered a flip and the added value can be captured without a tax hit.
Obtaining contracts or options on properties and then assigning the contract rights to a 3rd party is a common transaction type referred to a wholesaling. This is clearly a dealer transaction that will create UBTI.
Wholesaling presents other challenges, since it typically requires a lot of hustle, marketing, and personal involvement to generate opportunities. This level of personal effort could easily be viewed by the IRS as performing services to your IRA and a prohibited transaction.
An alternative to wholesaling that can work is what is referred to as earnest money lending or transactional lending. Your IRA or 401(k) can provide capital on a short-term basis to an individual that is out actively creating wholesale opportunities. The interest from such deals is passive income not subject to taxation.
Building property for sale is a business. There really is no question on that front.
If your IRA or 401(k) participates in the construction of property, but then holds onto that property as a rental for a reasonable period of time before selling – typically a year or more – that would change matters and produce passive income.
Having the plan provide construction financing in the form of a loan is a good way to participate in these opportunities and stay on the passive side of the ledger.
Acquiring raw land and then adding value to the land by sub-dividing and adding roads and utilities, then selling the lots off to builders is also something that can fall into the trade or business category, depending on scale and frequency.
If your IRA buys 150 acres of timberland with a lot or two that can be split off and developed for home sites, that may not be a big deal. The IRA could hold the timberland for the long term and sell the lots and likely not be considered engaging in a business.
Buying 20 acres on the edge of town and doing the work to prepare and sell 50 quarter-acre housing lots to builders would very much be a business activity.
Short Term Rentals
Short term corporate or vacation rentals are a bit of a gray area. If there is a limited level of such activity, and there are no services provided other than the rental of the space, this could be considered passive rental income.
With more than one or two properties, or if the rental comes with amenities like access to a private golf or beach club, meal and laundry service, or the like, then this could be viewed more like a hotel and therefore a services business subject to UBTI.
Self-Storage, Adult Care & Other Services
There are a handful of deal types that may seem like real estate investments because the focus of the opportunity is the property. Things like self-storage and adult care facilities are service businesses, however, and the income those businesses produce is considered UBTI.
An alternative that may or may not exist in either of these cases would be for an IRA or 401(k) to be part of a group that owns the property and leases the property to a separate operating business. A retirement plan can also hold a mortgage note secured by such a property and fall into the passive realm that way.
Know Before you Invest
Because it is your responsibility as the IRA account holder to operate within the IRS rules, you need to know in advance if a particular opportunity will generate UBTI. Be sure to check with your tax professional or Safeguard Advisors if you are unsure.