How can you avoid the tax on self directed IRA and multi fam

Question

I've researched a bit about the conversion on an IRA to a self-directed or solo 401K and how to avoid the UBIT tax on larger syndicated multi-family non-recourse deals. From what I can tell from some of the research it looks like you can only get the tax on returns down to about 21%, but I've heard that you can avoid it altogether.

The first question is, does anyone have a good reference to a company that can convert?

The second question is, has anyone done this and realized or seen the benefits or results yet?

The third question is, does anyone have a good reference to a tax or investment professional that has experience on this topic?

I know there is data out there on this, but nothing has been really clear and I would love to know.

Thanks, and make it a great day!!

Carl Fischer · Answer

@Chris D.

Good information provided above. Include IRS 990T instructions and forms with your research.

In addition the IRA can do a 1031 exchange and defer any taxes. In addition, if the debt is paid off a year before sale there is no tax upon the sale.

Pay strict attention to how the income is being reported on tax documents such as a K1 etc. Structuring deals is very important so consider the Ira being “debt” or “equity” owner when looking at investing in a syndication.

Brian Eastman · Answer

@Chris D.

When an IRA benefits from leverage there is a tax on the portion of the proceeds the IRA receives that are attributed to the non-IRA (borrowed) money.  This taxable income is referred to as UDFI.

I'm not sure where you got your 21% number, but that may be misleading.  It may be that in a certain range of income, the tax rate paid will be 21%, but that will only be on a small fraction of the overall income produced by the deal after factoring for deductions.

A typical $100K stake in a syndicate producing 10% returns will generate about $100-200 in tax liability per year.  That is a very small cost for being able to participate in a solid investment with leverage involved.

A Solo 401(k) is exempted from taxation on UDFI in some but not all cases.  Income from real estate debt is exempted.  When the investment is into a partnership, there are other restrictions such as equal treatment of all partners that need to be met in order for the exemption to apply.

If you are self-employed and have no full time employees, you may qualify for the Solo 401(k), which is a very nice self-directed retirement plan format.

If you are considering using retirement funds in a syndicated investment, be sure to review the situation with your tax professional (or find one who specializes in this area - several here on BP).  There are details that need to be evaluated and no two deals are alike.

The bottom line is that if an opportunity is a good deal and properly structured, it will be a good investment to make either in an IRA where there is tax exposure from UDFI or in a Solo 401(k) exempted from UDFI.

Justin Windham · Answer

@Chris D.

There are several providers of self-directed IRAs and 401ks that regularly post here on BP. Ditto for tax advisors. I'm sure you'll get some more responses.

Brian Eastman · Answer

@Chris D.

If a Solo 401(k) makes an investment in a debt-financed real estate syndicate, and that syndicate apportions all factors of income/expenses equally to all limited partner investors, then the 401(k) is exempted from UDFI taxation.  All income from the partnership is returned to the 401(k) on a tax-deferred basis, just like gains from dividends in the stock market. The 401(k) would not need to file form 990-T.

While the above is generally true, there can be exceptions.  If the syndicate operator is shifting depreciation around and allocating all benefits of depreciation to non-retirement plan investors, then the 401(k) can lose it's exemption to UDFI.  In that case, the 401(k) would have exposure to taxation on the portion of gains that are attributable to the debt-financing in the deal.  Not only would the Solo 401(k) now have taxable income, but the main deduction against that income - depreciation - would not be available.  Such a structure would be bad for an IRA or Solo 401(k) investor.  Thanks to @Eamonn McElroy for this insight, BTW.

Honestly, you are getting beyond where a web forum can answer your questions.  There are too many details that hinge on the specifics of a deal and your circumstances, sources of funds, etc.  Bottom line... if a syndicate opportunity is a better investment option than what your IRA is invested in today, get on the phone and start finding the right plan providers and tax advisors to help you take advantage.

If you qualify for a Solo 401(k) and can therefore avoid UDFI, great.  If not, the impact of UDFI in an IRA is not generally significant enough to turn a good investment into anything else.  You send the K-1 to your accountant and have them file a 990-T return for the IRA and smile when your IRA is bigger than it was the year before.

Justin Windham · Answer

@John Moore

I'd recommend searching the forums. There is more that has already been written about those companies in existing threads than members will likely end up posting in this specific thread. I'd pay particular attention to experiences reported by those with custodial control versus those with checkbook control. It can be eye-opening.

John Moore · Answer

I am wondering if anyone has advice on which trust company to go with? I am debating between several at the moment including Equity Trust and Entrust and I am wondering if anyone has experience or a preference for one or the other?

Chris R. · Answer

Brian thanks for clarifying.

I’m gathering as much info as I can here as I have not found anyone that can clearly answer the questions and those on this thread have. I appreciate the feedback. If you have a referral for these question I would appreciate it.

For the most part keeping is consistent and following the guidelines will keep an invested out of trouble with the tax man.

I can also message you direct.

Chris R. · Answer

Carl, when the 990T form is filed on an income/ or preferred return of $3000 from an investment originally  made by the solo 401k,  are there fees or taxes that could be due?

It looks like some of the tax code describes this, but I though as long as the income or profit were deposited right back to the solo 401k that the investment originated for it was tax exempt.

Chris R. · Answer

Perfect! They sounded the same but one of my counterparts was insisting there was possibly a difference.

Makes perfect sense.

Brian Eastman · Answer

@Chris D.  QRP stands for Qualified Retirement Plan.  A version of a QRP is a Solo 401(k), which is designed for owner-only businesses.  Solo 401(k) plans are very easy to self-administer due to lack of managing any employee savings.

Other types of QRP's exist for businesses that have qualifying employees. Some marketers like to use the term QRP when they are really talking about Solo 401(k) plans to make themselves sound different for some reason.  (shiny objects?)  There are others who like to market more complex employee-capable plans to single owner businesses, using somewhat reasonable arguments about stronger protections under ERISA in such plans in the event of a catastrophe such as bankruptcy.  The challenge is that the administration of those plans is so much more complex and expensive it is not worth it for most investors.

How can you avoid the tax on self directed IRA and multi fam

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