First of all, I'd like to commend all you house flippers out there. Flipping houses isn't easy--not unlike some less honorable professions. But you know what makes it a little easier? Avoiding unnecessary contributions to Uncle Sam. Let's talk about the best way to flip houses and limit or avoid UBTI/UBIT.
With a Self-Directed IRA, you can flip homes or engage in real estate transactions funded with your retirement savings by simply writing a check. As owner of your Self-Directed IRA LLC, you will have the authority to make real estate investment decisions on your own without having to wait for the consent of an IRA custodian.
Another advantage of using a Self-Directed IRA to flip homes is when you want to purchase a home with your self-directed IRA, you can make the purchase, pay for the improvements, and sell or flip the property on your own without involving an IRA custodian.
Did I forget to tell you all the money you make from flipping houses using a Self Directed IRA will be tax free? This is true, believe it or not. However, there are a few things you need to watch out for.
When engaging in a real estate transaction, like flipping a house, you should always be mindful of the Unrelated Business Taxable Income rules (also known as UBTI or UBIT).
The purpose of the UBTI and UBIT rules is to make sure those who are traditionally tax exempt, (IRA's, charities and 401k's) are taxed as a for-profit business when they engage in active business activities or use leverage.
The UBTI or UBIT rules generally applies to the taxable income of “any unrelated trade or business…regularly carried on” by an organization subject to the tax. The regulations separately treat three aspects of the quoted words—“trade or business,” “regularly carried on,” and “unrelated.”
Overview of The Three UBTI/UBIT Aspects
Trade or Business
The rules start with the concept of “trade or business” listed by Internal Revenue Code Section 162, which allows deductions for expenses paid or incurred “in carrying on any trade or business.”
The tax code is vague on this issue, but by using Section 162 as a reference you can limit the term “trade or business” to profit oriented activities involving the tax exempt entity. Let's break down the language.
The UBIT or UBIT rules only applies to income of an unrelated trade or business that is “regularly carried on” by an organization.
Whether a trade or business is "regularly carried on" is determined by comparing what the tax exempt entity does to non-tax exempt entities. Basically, tax exempt entities can't do things that are deemed "commercial".
Unless they want to start paying taxes.
In the case of an IRA or 401k plan, any business activity will be treated as “unrelated” to its exempt purpose. This can be confusing, I know.
For IRA's and 401k's, a transaction would not trigger the UBTI or UBIT rules if the transaction is deemed not to be considered a trade or business that is "regularly carried on".
Activities which wouldn't trigger UBIT OR UBTI include capital gains, interest, rental income, royalties, and dividends generated by the IRA/401k. The passive income exemptions to the UBTI or UBIT rules are listed in Internal Revenue Code Section 512.
But if you, as a tax exempt entity, engage in an active trade or business, such as a restaurant, store, or manufacturing business, the IRS will tax the income from the business since the activity is an active trade or business that is regularly carried on.
So now you're probably wondering what kind of real estate transaction will trigger the UBTI or UBIT taxes. As I mentioned earlier, the IRS is unfortunately vague on issues like this. What a coincidence, right?
There's no telling how many houses you have to flip in order to trigger the UBTI or UBIT tax. But the IRS does have a number of factors it will use to determine whether you've engaged in a high enough volume of real estate transactions, such as home flipping, to trigger the UBTI or UBIT tax.
3 Factors The IRS Uses:
If it's determined that an activity/transaction you engaged in is an active trade or business transaction, you will trigger the UBTI or UBIT tax, which is taxed at a rate of approximately 40% for 2017.
The 40% rate can be lower or higher, depending on the facts and circumstances of your situation. What you should know is that one or two flipping transactions per year wouldn't be considered an active trade or business and wouldn't trigger the UBTI or UBIT tax.
Now, knowing the real estate tycoon that you are, you're probably asking yourself, what happens if you do 4 or 5, or even 10 flipping transactions in a year? Would that be considered an active trade or business causing the UBTI/UBIT taxes to get triggered?
The answer to your question largely depends on the circumstances of your unique situation. It's all about how and why you flip the houses, not how many you flip. At least, that's how your friends at IRS see it anyway.
Scott Royal Smith is an asset protection attorney and long-time real estate investor. He's on a mission to help fellow investors free their time, protect their assets, and create lasting wealth.
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