Self-directed IRAs offer the best of many worlds. That includes having full custodianship over the IRA trust and the ability to make any decisions concerning the trust. For instance, buying and selling a property can be as easy as writing a check. Any gains made from the sale are paid to the trust tax-free.
The one thing that an investor needs to be aware of is UBTI (Unrelated Business Taxable Income Rules), which is sometimes also known as UBIT. Under UBTI, non-taxable entities such as IRAs may be treated as for-profit entities (and thus taxed) given certain conditions. The question then becomes: what re those conditions and do they apply to house flipping?
Firstly, UBTI applies to the taxable income of “any unrelated trade or business regularly carried on” by an organization that would otherwise be subject to the tax. There are three aspects to this that need to be understood. Those are:
- Trade or business
- Regularly carried on
The language itself is ambiguous. The actual law is less so.
UBTI Income Rules Explained
In terms of an IRA or 401(k), any trade or business may be deemed unrelated to the general function of a retirement fund. The UBTI, however, is only interested in preventing businesses that are engaged in a competitive market with other businesses to gain an advantage by using tax-free or tax-deferred status. Strictly speaking, the UBTI is never going to be triggered by income derived from passive gains, such as interest, rent, royalties, and dividends.
But a business like a store or restaurant would be subject to taxes, even if held in an IRA. How, then, does this apply to house flipping?
UBTI and House Flipping
The question most people ask themselves is: “what exactly is the threshold for regularly carried out?” The truth is, there isn’t one. The IRS is likely to employ a three-factor test in determining whether or not an individual’s house flipping activities cross the line. Those include:
- The frequency of transactions
- The intent of the individual
- Other activities claiming tax-exemptions
The main factor is whether or not the flipping of the houses constitutes a business. It would, of course, not be ok to have a business that you’re actively engaged in the management of trying to get out of paying taxes. On the other hand, buying a house, fixing it up, and then selling it off is unlikely to trigger a visit from the IRS.
Ultimately, the IRS will make a determination based on whether or not you’re attempting to use your IRA to get out of paying taxes. If you’re operating a business from your IRA, then the IRS is likely to frown upon that. If you flip one or two houses a year using IRA money, then the IRS is unlikely to care.
Clearly, IRAs were not designed for the purpose of flipping houses. Nor does that mean that an individual would be prohibited from using their IRA to do so. So what exists is a legal gray area that, under the proper circumstances, can be exploited fo the purpose of padding your retirement account. For those who are interested, working with a tax professional will help avoid triggering a UBTI audit.