What did you love/hate using your self-directed IRA to invest?

Question

I have not used my self-directed IRA (SDIRA) to invest in a multifamily syndication yet and would love to understand from other investors what you loved/hated about your experience... Thanks!

Brian Eastman · Answer

@Ned Carey

The language in the post you question is not particularly precise.  When it comes to IRA related tax matters, very few posts here on Bigger Pockets get it right.  It is a complex topic best left to professionals.

A tax-exempt IRA or 401(k) is subject to tax on income generated by participation in a trade or business carried on with regularity.  This tax on Unrelated Business Taxable income (UBTI) is designed to level the playing field for tax-paying businesses and prevent unfair competition from tax-exempts in activities deemed to be commercial enterprises.

In real estate, activities that create UBTI include dealer transactions such as flipping and wholesaling, new construction for immediate sale, and services associated real estate such as hotels, short-term rentals, self-storage, and adult care homes.

Rent from real property, interest on notes, and the sale of a property or note held over time all generate passive income with no UBTI component.

A syndication is not a business simply by the fact that a “business entity” such as a LLC or LLP is used to put the project together.  Many people get this point wrong.  The underlying income producing activity is what matters when it comes to taxation.  If a syndication is producing income via passive rents or interest, no UBTI is generated.  If a syndication is producing income via a trade or business such as flipping or self-storage, then it does produce UBTI.

A pass-through entity such as a sole proprietorship, LLC, or LLP will pass its tax liability to owners, so limited partnership interests in a syndication will have tax exposure when the activity of the entity produces trade or business income.  To your point about investing in public corporations, they are all structured as subchapter C corporations and pay corporate tax on income before issuing passive income in the form of dividends to shareholders.  Dividend income is not UBTI generating.

Brian Eastman · Answer

@Lane Kawaoka

Tax on UDFI should not be a big deal.  In the example you note, there is not likely even any tax impact.

While 75% of income is taxed, you also get to use 75% of allowable deductions such as depreciation, interest on the note, etc.  the net taxable income is so low as to be below the $1000 reportable threshold.

I ran your numbers through a calculator we have on our website and there was a $0 tax due amount for a 5 year hold assuming 10% income and 30% expense ratio.

Leverage creates a higher cash on cash return.  In an IRA, that leverage has a small tax cost.  The tax cost is generally a good bit less than the boost in return, so you still get a net higher cash-on-cash returned from leveraged property purchases in an IRA.

If you say "Taxes are going to cost me $4000 (or whatever)" that sounds discouraging.  If you say "My leveraged investment produced $70K more than an equivalent all-cash deal, but it did cost me $4000 in taxes"....

So, using a self-directed IRA opens up the possibility of investing in real assets and using leverage.  Can an IRA at E*Trade do that?  Nope.

Alina Trigub · Answer

@Joseph Firmin

Prior to opening up a regular SDIRA with custodian, find out if you're qualified for a solo-401k which is a much better option overall. If not look into checkbook IRA to decide whether that's an option you'd select over a regular SDIRA.

Brian Eastman · Answer

@Alina Trigub

Storage is considered to be a service.  The income is not classified as rents from real property, and is therefore not exempted from UBTI.

https://www.irs.gov/charities-non-profits/exclusion-of-rent-from-real-property-from-unrelated-business-taxable-income

Lane Kawaoka · Answer

I don't really like investing in syndications with qualified retirement money.

When you invest in a business (syndicate = business) with your IRA, the IRA will be subject to UBIT (unrelated business income tax) and UDFI (unrelated debt financed income).

For our purposes, UDFI is produced when an IRA uses debt to purchase real estate. Essentially, the portion of the property’s income considered UDFI is based on the percentage of rental income derived from debt.

For example, Property A is purchased for $100,000. You put down 25% of the purchase price as a down payment and finance the remaining 75% with a traditional mortgage from the bank. The property produces $10,000 in net income for the year. $7,500 (75%) of the net income is considered UDFI and is subject to UBIT.

There is a deduction for the first $1,000 of income subject to UBIT. Income subject to UBIT over $1,000 is taxed at trust rates. For 2017, trust tax rates start at 15% and max out at 39.6% after just $12,400 of income subject to UBIT.

UBIT is paid by the IRA account. If for whatever reason UBIT is paid directly by the taxpayer, the amount paid is considered a contribution to the IRA.

Brian Eastman · Answer

@Ned Carey

To your specific point about Google or GM or other public stock, yes.  Those are corporations issuing passive dividends.  Similarly, a non-traded private corporation would issue dividends.

In a pass through, you do not automatically have tax exposure.  If the income generating activity of the pass through entity is passive such as interest or rent from real property, there is no tax implication for an IRA/401(k) investor (unless leverage is used, which is an entirely different topic).  If the income generating activity of the pass through entity is active trade or business income from an operating business, then UBTI occurs.

Taylor L. · Answer

The worst part of the process I've had happen is when the sponsor isn't responsive with filling out forms and such. It doesn't happen often, but when it does it's very inconvenient. Nothing bad with the IRA company yet.

Jeff S. · Answer

Having Preferred Trust recommended but don't know anything about them @Joseph Firmin. Wondering if should go with to invest in Trust Deeds.

Tony Lin · Answer

I have invested in 4 multi-families syndications with SDIRA money. No issues except that some banks are hard to deposit into. There was a lot of trouble doing ACH deposits into Fidelity and Schwab IRA accounts. It turned into checks I have to go the bank each month and it's kind of annoying. Schwab didn't allow mobile phone deposits either because it's a special type of account type.

All else aside, they've been doing fine. I really love the flexibility to invest in more asset classes than just stocks.

What did you love/hate using your self-directed IRA to invest?

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