Self-directed IRAs (“SDIRA”) are increasing in popularity. More and more investors are getting bored with traditional investments (stocks, bonds, mutual funds, etc) and seeking out alternative investments in the search for higher returns. The SDIRA landscape is changing as a variety of investments are being introduced to the market.
There is no doubt that SDIRAs are very flexible options and allow for a diverse set of investments. They can invest in almost anything, except for life insurance, S-Corp stock and certain types of collectibles. The problem is that there is often confusion about SDIRA tax rules. Compounding the issue is that the majority of CPAs don’t understand the complexity associated with them. It’s not that CPAs are naive to the issues it is just that they are not faced with them on a daily basis in their practices.
But even though an SDIRA can invest in most things, certain investments can trigger immediate tax issues. This is where the complexity lies. The two main issues for SDIRAs relate to income from a trade or business that is regularly carried on (this can be directly or indirectly) or income generated from debt-financed property. These issues are identified herein as: (1) unrelated business taxable income (“UBTI”); and (2) unrelated debt-financed income (“UDFI”). Let’s take a closer look at these issues and then see how they apply to partnership syndications and real estate crowdfunding.
Unrelated Business Taxable Income
UBTI is generally defined as the gross income derived from any unrelated trade or business regularly conducted by the exempt organization, less any deductions associated with carrying on the trade. The business or trade itself needs to be “regularly carried on” in order to trigger UBTI.
So in most situations, UBTI occurs when an SDIRA owns a portion of an operating business (retail store, service business, etc). Rents from real property are specifically excluded in computing UBTI, but may be subject to UDFI. Interest income, dividends, royalties, annuities and other investment income are also typically exempt from UBTI but can be subject to other limitations (such as UDFI).
Unrelated Debt-Financed Income
UDFI is another issue that is important to consider. It is generally defined as any property held to produce income for which there is acquisition indebtedness at any time during the tax year. It also includes gains from the disposition of such property. UDFI applies to corporate stock, tangible personal property, and more importantly – real estate.
What this means in practice is that if your self-directed IRA acquires a rental home for $100,000 with a 25,000 down payment and obtains a $75,000 loan to finance the purchase, approximately 75% of the income generated by the property would be subject to UDFI. The UDFI calculation is actually a little more complex. It is calculated as the percentage of average acquisition indebtedness for a tax year divided by the property’s average adjusted basis for the year (average debt/average basis).
Real Estate Syndications and Crowdfunding
So now let’s take a look at how UBTI and UDFI would apply as we examine syndications and real estate crowdfunding. There are essentially two types of deals when it comes to real estate syndication or crowdfunding: (1) equity; and (2) debt. An equity deal is basically when an investor owns shares in a limited liability company (“LLC”) that either acquires a parcel of real estate or invests into another LLC that acquires real property. The investor holds an indirect equitable interest in the property and is taxed as a partner in a partnership. Equity investors receive a Form K-1 at the end of the tax year that will report their share of the partnership’s income or loss.
In a debt deal the investor typically owns an interest in a promissory note that is issued for short-term financing on a real estate project. Investors in debt deals typically do not participate in any upside in the property and are merely acting as just investors. Accordingly, any payments they receive are typically classified as interest income.
Unfortunately, UBTI and UDFI extend to partners in partnerships. If a partnership that owns rental real estate has a partner that is an SDIRA then the rules for UDFI will be extended to the partners. Accordingly, if there is debt financing at the partnership level, then any income or loss will flow through to the partners along with the UDFI issue. The partner is treated as if it had conducted the real estate activity in its own capacity and the IRS does not make any distinction between limited and general partners. In addition, it does not matter whether or not actual cash distributions have been made.
So in a real estate syndication equity deal, rental income that is allocated to an SDIRA would partially be subject to tax under the UDFI rules (assuming financing was obtained for the property). In many cases though you may find that the tax consequences will be minimal due to depreciation that is passed through from the real estate held by the partnership.
However, the SDIRA will often still be required to file a tax return. Even if no tax is due, it generally a good idea to file a tax return so that any capital gains from the ultimate sale of the real estate (which is also be partially taxable due to the debt financing) are offset by any carryover losses that have generated over the years.
So what are the tax filing requirements if you have UBTI or UDFI? First, a filing is only required if there is gross income of $1,000 or more. Gross income is defined as gross receipts minus the cost of goods sold. Assuming this criteria is met, Form 990-T, Exempt Organization Business Income Tax Return, must be filed and the tax paid accordingly. Tax rates can be high because IRAs are taxed at trust rates. For tax year 2013, any income above $11,950 is taxed at 39.6%. State taxes will also need to be considered.
So just because an SDIRA can invest is almost anything, you must consider any immediate tax consequences. UBTI and UDFI are important considerations when it comes to real estate syndication and crowdfunding. UDFI is all too often overlooked and can certainly be a problem in an equity deal.
It is important to note that each deal is structured differently, so make sure that you do your own due diligence. As always, before you consummate any transaction make sure that you review the tax consequences and filing requirements with your CPA.
Tax and Legal Advice Disclaimer: AlphaFlow and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.