Dec 27

How to Use an Individual 401(k) Loan to Make Investments

When it comes to using retirement funds, such as a Solo 401K Plan, to make investments, the question arises whether you can take a 401(k) Loan as part of the transaction.

How to Use an Individual 401(k) Loan to Make InvestmentsThe IRS has always allowed a Solo 401K Plan to make traditional as well as non-traditional investments such as real estate. However, the prohibited transaction rules under Internal Revenue Code Section 4975 restrict a Solo 401(k) Plan participant from engaging in certain transactions – prohibited transactions. Under IRC 4975, one of the categories of prohibited transactions involve a disqualified person personally guaranteeing a loan made to a Solo 401K Plan. A Solo 401K plan participant is treated as a disqualified person pursuant to IRC 4975. As a result, a Solo 401K, also known as an Individual 401K or Self Directed 401K Plan, cannot use a recourse loan to purchase property owned by a Plan because a disqualified person (Solo 401K Plan participant) cannot personally guarantee a loan. However, the IRS does allow for the 401K to use a nonrecourse loan to purchase real estate. A nonrecourse loan is a loan that does not require a personal guarantee on the part of the Solo 401K plan participant. In other words, a loan that would limit a lender’s (bank) ability to go after an individual personally for non-payment of the loan. Instead, the lender’s sole remedy would be to look to the underlying property as satisfaction of the loan. Of course, this type of loan is more difficult to acquire and can be more expensive for a borrower.

In general, Internal Revenue Code Section 514(c)(9) permits a few types of exempt organizations to make debt-financed investments in real property without becoming taxable under Code Section 514. Note – the exemption only applies to real estate and not to other types of nonrecourse financing, such as margin on stock.

The Section 514 exemption applies to any “qualified organization,” a term that includes (1) schools, colleges, universities, and their “affiliated support organizations,” (2) qualified pension, profit sharing, and stock bonus trusts, and (3) title holding companies exempt under § 501(c)(25). In general, indebtedness incurred by a qualified organization in acquiring or improving real property is not acquisition indebtedness if the transaction navigates through a long list of prohibitions. In other words, a Solo 401K Plan can use nonrecourse leverage when purchasing real property with Plan assets and not be subject to the Unrelated Debt-Financed Income rules, which in-turn trigger an Unrelated Business Taxable Income (UBTI or UBIT) tax (approximately 40% for 2017). Note – only nonrecourse leverage can be used when acquiring property by a 401K or Solo 401K Plan since, a disqualified person (401(k) plan participant or trustee) cannot personally guarantee the loan (recourse loan) since that would violate the prohibited transaction rules pursuant to Internal Revenue Code Section 4975. It is important to remember that this exemption would not apply to an IRA since an IRA is not a qualified pension, profit sharing, and stock bonus trusts.

To satisfy the exemption under Internal Revenue Code Section 514, the price paid by the organization for the property or improvement must be fixed when the property is acquired or the improvement is completed, neither the amount nor the due date of any payment under the indebtedness can be contingent on the revenue, income, or profits from the property, and the property may not be leased to the person who sold the property to the organization or to any person related to the seller within the meaning of Code Section 267(b) or Code Section 707(b). If the organization is a qualified pension, profit sharing, or stock bonus trust, the property may not be purchased from or leased to the employer of any of the employees covered by the trust or any one of several persons related to the employer. Financing for the property may not be received from the person who sold the property to the organization, a person related to the seller within the meaning of Code Section 267(b) or Code Section 707(b), or, if the organization is a qualified employee trust, an employer or related person who is disqualified from being seller or lessee under the rule described in the preceding sentence. The property must usually be owned directly by the qualified organization, except that an interest in a partnership or other pass-through entity qualifies if all of the partners or other owners are qualified organizations and each partner or other owner is allocated the same distributive share of every item of partnership income, deduction, and credit.

When § 514(c)(9) was enacted in 1980, it applied only to qualified pension, profit sharing, and stock bonus plans, but its scope was broadened in 1984 to include schools, colleges, and universities.

Many people ask why this exemption only applies to 401K Plans and not IRAs. The only reason given in the committee reports for the exemption is that some people wanted it: “Trustees of these plans are desirous of investing in real estate for diversification and to offset inflation. Debt-financing is common in real estate investments.” The provision was originally limited to qualified employee trusts on the theory that the income would eventually be taxed to employees and their beneficiaries.

To learn more about the rules surrounding using a loan with a Solo 401K Plan to make an investment please contact a Solo 401K Expert at 800-472-0646.

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Jul 31

What The Law Says About UBTI In Non-Real Estate Investments

This article, written by Adam Bergman, about the UBTI rules when making non-real estate investments, first appeared on Forbes.com

For many retirement account investors, understanding how the Unrelated Business Taxable Income Rules work, also known as UBTI, UBIT, or debt-financed income rules, and how they may potentially apply to one’s retirement account investment has been a challenge.  The main reason is that the majority of IRA or 401(k) plan investors invest in traditional types of investments, such as equities, mutual funds, and ETFs, which do not trigger the application of the UBTI tax rules since most passive investments that a retirement account might invest in are exempt from the UBTI rules, such as interest, dividends, and capital gains.

Understanding the potential impact of the UBTI rules is crucial for retirement account investors Understanding the potential impact of the UBTI rules is crucial for retirement account investors seeking to make non-real estate alternative investments in their retirement accounts, including options, stock short sales, and commodity futures contracts.  In general, the UBTI tax rules are triggered in three instances: (i) use of margin to buy stock, (ii) use of a nonrecourse loan to buy real estate, and (iii) investment in a business operated through a flow-through entity, such as an LLC or partnership.  The tax imposed by triggering the UBTI rules is quite steep and can go as high as 40 percent.

When it comes to non-real estate transactions, such as securities and other financial products involving retirement funds, understanding the application of the UBTI or debt-financed income rules have been somewhat difficult. Neither the Code nor the Treasury regulations define “indebtedness” for purposes of the debt-financed income rules. Generally, when a retirement account borrows funds and has a clear obligation to repay the funds, the debt-financed income rules are applicable. However, many financial product type investments that involve “leverage” but not a direct borrowing are not considered debt-financed property and are not subject to UBIT.

Below is a summary of how the UBTI/debt-financed income rules apply to some of the more common type of financial product investments involving retirement funds:

Purchase of Stock or Securities on Margin:  It is well established that the purchase of securities on margin gives rise to unrelated debt-financed income (Elliott Knitwear Profit Sharing Plan v. Commissioner, 614 F.2d 347 (3d Cir. 1980).

Repurchase Agreements:  In a repurchase agreement, one party (usually a bank) purchases securities from another party (the bank’s customer) and agrees to sell the securities back to the customer at an agreed price. Such transactions are treated as a loan of money secured by the securities and give rise to unrelated debt financed income (Rev. Rul. 74-27, 1974-1)

Securities Lending Transactions: IRC Section 514(c)(8) provides that payments with respect to securities loans are deemed to be derived from the securities loaned, not from collateral security or the investment of collateral security from such loans.

Short Sales of Stock: The IRS has ruled that neither the gain attributable to the decline in the price of the stock sold short nor the income earned on the proceeds of the short sale held as collateral by the broker constituted debt-financed income (Rev. Rul. 95-8, 1995-1)

Options: IRC Section 512(b)(5) excludes from UBTI all gains or losses recognized, in connection with an organization’s investment activities, from the lapse or termination of options to buy or sell securities.

Commodities Futures Transactions: The IRS has concluded that gains and losses from commodity futures contracts are excluded from UBTI under Code section 512(b)(5). The IRS has rules that the purchase of a long futures contract entailed no borrowing of money in the traditional sense.  Likewise, the IRS found a short contract was merely an executory contract because there was no property held by the short seller that produced income and thus there could be no acquisition indebtedness.

Notional Principal Contracts: The IRS has issued regulations providing that all income and gain from notional principal contracts is excluded from UBTI. (Treas. Reg. § 1.512(b)-1(a)(1).)

The Internal Revenue Code permits retirement account investors to make a wide range of financial product investments using retirement funds. While the majority of financial product type investments would not trigger the UBTI or debt-financed income rules, (including mutual funds and options) transactions involving margin, however, would likely trigger the tax.  The burden falls on the retirement account holder to make the determination of whether the financial product type transaction triggered the UBTI rules and, if so, file the IRS Form 990-T. Therefore, it is important to work with a tax professional who can help one evaluate the financial product transaction to determine whether the transaction will trigger the UBTI or debt-financed income rules tax.

For more information, please contact the IRA Financial Group @ 800.472.0646!

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Jun 20

Does the UBTI Tax on Unrelated Debt Financed Income Apply to Solo 401k Plans?

No. Unlike a Self Directed IRA LLC, when a Solo 401K Plan uses nonrecourse leverage to purchase real estate that is leveraged, it is exempt from paying any Unrelated Business Taxable Income (UBTI) tax on the income or gain generated.

When an IRA buys real estate that is leveraged with mortgage financing, it creates Unrelated Debt Financed Income (a type of Unrelated Business Taxable Income) on which taxes must be paid. A Solo 401(k) plan is exempt from UDFI pursuant to Internal Revenue Code Section 514(c)(9).

With the UBTI tax rates at approximately 40% for 2017, the Solo 401(k) Plan offers real estate investors looking to use nonrecourse leverage in a transaction with a tax efficient solution.

Does the UBTI Tax on Unrelated Debt Financed Income Apply to Solo 401k Plans?“Debt-financed property” refers to borrowing money to purchase the real estate (i.e., a leveraged asset that is held to produce income). In such cases, only the income attributable to the financed portion of the property is taxed; gain on the profit from the sale of the leveraged assets is also UDFI (unless the debt is paid off more than 12 months before the property is sold).

Why does this Exemption Apply to 401(k) Plans and Not IRAs?

When Internal Revenue Code Section 514(c)(9) was enacted in 1980, it applied only to qualified pension, profit sharing, and stock bonus plans, but its scope was broadened in 1984 to include schools, colleges, and universities. The provision brings the history of Internal Revenue Code Section 514 full circle by exempting some organizations, such as 401(k) Qualified Plan, from tax on income from the very sort of leveraged real estate deals that provoked the enactment of the predecessor of Internal Revenue Code Section 514 in 1950. As per the legislative history, the only reason given in the committee reports for the exemption is that some people wanted it: “Trustees of these plans are desirous of investing in real estate for diversification and to offset inflation. Debt-financing is common in real estate investments.”

Please contact one of our 401(k) Experts at 800-472-0646 for more information.

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Mar 30

Do You Have to Pay UBTI Tax on Unrelated Debt Financed Income in a Solo 401(k) Plan?

No. Unlike a Self Directed IRA LLC, when a Solo 401K Plan uses nonrecourse leverage to purchase real estate that is leveraged, it is exempt from paying any Unrelated Business Taxable Income (UBTI) tax on the income or gain generated.

When an IRA buys real estate that is leveraged with mortgage financing, it creates Unrelated Debt Financed Income (a type of Unrelated Business Taxable Income) on which taxes must be paid. A Solo 401(k) plan is exempt from UDFI pursuant to Internal Revenue Code Section 514(c)(9).

With the UBTI tax rates at approximately 40% for 2017, the Solo 401(k) Plan offers real estate investors looking to use nonrecourse leverage in a transaction with a tax efficient solution.

Debt-financed property refers to borrowing money to purchase the real estate (i.e., a leveraged asset that is held to produce income). In such cases, only the income attributable to the financed portion of the property is taxed; gain on the profit from the sale of the leveraged assets is also UDFI (unless the debt is paid off more than 12 months before the property is sold).

Why does this Exemption Apply to 401(k) Plans and Not IRAs?

When Internal Revenue Code Section 514(c)(9) was enacted in 1980, it applied only to qualified pension, profit sharing, and stock bonus plans, but its scope was broadened in 1984 to include schools, colleges, and universities. The provision brings the history of Internal Revenue Code Section 514 full circle by exempting some organizations, such as 401(k) Qualified Plan, from tax on income from the very sort of leveraged real estate deals that provoked the enactment of the predecessor of Internal Revenue Code Section 514 in 1950. As per the legislative history, the only reason given in the committee reports for the exemption is that some people wanted it: “Trustees of these plans are desirous of investing in real estate for diversification and to offset inflation. Debt-financing is common in real estate investments.”

Please contact one of our 401(k) Experts at 800-472-0646 for more information.

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Feb 28

Solo 401k and UDFI Rules When Buying Real Estate

One of the advantages of using retirement funds, such as a Solo 401(k) plan, to make investments is that, in most cases, all income and gains from the investment will flow back to the 401(k) plan tax-deferred or tax-free in the case of a Roth. This is because a 401(k) plan is exempt from tax pursuant to Internal Revenue Code (“IRC”) Section 401.  In addition, IRC Section 512 exempts most forms of investment income generated by a 401(k) from taxation.  Some examples of exempt types of income include: interest from loans, dividends, annuities, royalties, most rentals from real estate and gains/losses from the sale of real estate.

However, the IRS enacted a set of rules in the 1950s in order to prevent tax-exempt organizations, such as charities and later 401(k) and IRAs from engaging in an active trade or business not related to its exempt purpose and thus, having an unfair advantage because of their tax-exempt status. These rules have become known as the Unrelated Business Taxable Income rules, also known as UBTI or UBIT. If the UBTI rules are triggered, the income generated from that activities would generally be subject to close to a 40% tax for 2017.  The type of income that generally could subject a retirement plan to UBIT is income generated from the following sources:

  • Income from the operations of an active trade or business through a pass-through entity (i.e. LLC or partnership), such as a restaurant. Of note, a retirement account investing in an active trade or business using a C Corporation will not trigger the UBTI tax.
  • Using margin on a stock purchase.
  • Nonrecourse leverage to purchase real estate (a nonrecourse loan is a loan not personally guaranteed by the plan participant). Only a nonrecourse loan can be used, as a recourse loan (a loan personally guaranteed by the plan participant) would trigger a prohibited transaction under IRC Section 4975.

Solo 401k and UDFI Rules When Buying Real EstateWhen a retirement account buys real estate that is leveraged with mortgage financing, it creates Unrelated Debt Financed Income (“UDFI”), a type of UBTI on which taxes must be paid.  However, a 401(k) plan is exempt from UDFI pursuant to IRC Section 514(c)(9), which allows a few types of exempt organizations, such as schools, colleges, universities, and their “affiliated support organizations” as well as qualified pension, profit sharing, and stock bonus trusts, but not IRAs, to make debt-financed investments in real property without becoming taxable under IRC Section 514. Generally, debt financed investments by a qualified organization in acquiring or improving real property will be exempt from the UDFI tax rules if the transaction navigates through a long list of prohibitions set forth under IRC 514(c)(9).  The price paid by the organization for the property or improvement must be fixed when the property is acquired or the improvement is completed, neither the amount nor the due date of any payment under the indebtedness can be contingent on the revenue, income, or profits from the property, the property may not be leased to the person who sold the property to the organization (sales and leaseback), and the qualified organization must hold the real estate directly.  However, if the qualified organizations owns an interest in a partnership that holds an interest in real estate (i.e. real estate fund), the exemption to the UDFI rules can still be satisfied if the partnership satisfies the aforementioned restrictions and one additional rule, that can be satisfied in any of three ways:

  • All partners are qualified organizations,
  • All allocations of tax items from the partnership must be qualified allocations
  • Allocations must satisfy the “fractions rule”

Using a 401(k) plan to purchase real estate using nonrecourse leverage is generally more tax advantageous than using an IRA so long as one can satisfy the list of prohibitions under IRC 514(c)(9).  Because of the complexity of the rules, one should consult with a tax attorney for more specific information on this subject.

For more information about the UDFI rules when using a Solo 401(k) to invest in real estate, please contact us @ 800.472.0646.

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Nov 22

How to Use a Loan From Your Solo 401k to Make an Investment

When it comes to using retirement funds, such as a Solo 401K Plan, to make investments, the question arises whether a Solo 401K Plan can utilize a loan as part of the transaction.

The IRS has always allowed a Solo 401K Plan to make traditional as well as non-traditional investments such as real estate. However, the prohibited transaction rules under Internal Revenue Code Section 4975 restrict a Solo 401(k) Plan participant from engaging in certain transactions – prohibited transactions. Under IRC 4975, one of the categories of prohibited transactions involve a disqualified person personally guaranteeing a loan made to a Solo 401K Plan. A Solo 401K plan participant is treated as a disqualified person pursuant to IRC 4975. As a result, a Solo 401K, also known as an Individual 401K or Self Directed 401K Plan, cannot use a recourse loan to purchase property owned by a Plan because a disqualified person (Solo 401K Plan participant) cannot personally guarantee a loan. However, the IRS does allow for the 401K to use a nonrecourse loan to purchase real estate. A nonrecourse loan is a loan that does not require a personal guarantee on the part of the Solo 401K plan participant. In other words, a loan that would limit a lender’s (bank) ability to go after an individual personally for non-payment of the loan. Instead, the lender’s sole remedy would be to look to the underlying property as satisfaction of the loan. Of course, this type of loan is more difficult to acquire and can be more expensive for a borrower.

In general, Internal Revenue Code Section 514(c)(9) permits a few types of exempt organizations to make debt-financed investments in real property without becoming taxable under Code Section 514. Note – the exemption only applies to real estate and not to other types of nonrecourse financing, such as margin on stock.

How to Use a Loan From Your Solo 401k to Make an InvestmentThe Section 514 exemption applies to any “qualified organization,” a term that includes (1) schools, colleges, universities, and their “affiliated support organizations,” (2) qualified pension, profit sharing, and stock bonus trusts, and (3) title holding companies exempt under § 501(c)(25). In general, indebtedness incurred by a qualified organization in acquiring or improving real property is not acquisition indebtedness if the transaction navigates through a long list of prohibitions. In other words, a Solo 401K Plan can use nonrecourse leverage when purchasing real property with Plan assets and not be subject to the Unrelated Debt-Financed Income rules, which in-turn trigger an Unrelated Business Taxable Income (UBTI or UBIT) tax (approximately 40% for 2016). Note – only nonrecourse leverage can be used when acquiring property by a 401K or Solo 401K Plan since, a disqualified person (401(k) plan participant or trustee) cannot personally guarantee the loan (recourse loan) since that would violate the prohibited transaction rules pursuant to Internal Revenue Code Section 4975. It is important to remember that this exemption would not apply to an IRA since an IRA is not a qualified pension, profit sharing, and stock bonus trusts.

To satisfy the exemption under Internal Revenue Code Section 514, the price paid by the organization for the property or improvement must be fixed when the property is acquired or the improvement is completed, neither the amount nor the due date of any payment under the indebtedness can be contingent on the revenue, income, or profits from the property, and the property may not be leased to the person who sold the property to the organization or to any person related to the seller within the meaning of Code Section 267(b) or Code Section 707(b). If the organization is a qualified pension, profit sharing, or stock bonus trust, the property may not be purchased from or leased to the employer of any of the employees covered by the trust or any one of several persons related to the employer. Financing for the property may not be received from the person who sold the property to the organization, a person related to the seller within the meaning of Code Section 267(b) or Code Section 707(b), or, if the organization is a qualified employee trust, an employer or related person who is disqualified from being seller or lessee under the rule described in the preceding sentence. The property must usually be owned directly by the qualified organization, except that an interest in a partnership or other pass-through entity qualifies if all of the partners or other owners are qualified organizations and each partner or other owner is allocated the same distributive share of every item of partnership income, deduction, and credit.

When § 514(c)(9) was enacted in 1980, it applied only to qualified pension, profit sharing, and stock bonus plans, but its scope was broadened in 1984 to include schools, colleges, and universities.

Many people ask why this exemption only applies to 401K Plans and not IRAs. The only reason given in the committee reports for the exemption is that some people wanted it: “Trustees of these plans are desirous of investing in real estate for diversification and to offset inflation. Debt-financing is common in real estate investments.”  The provision was originally limited to qualified employee trusts on the theory that the income would eventually be taxed to employees and their beneficiaries.

To learn more about the rules surrounding using a loan with a Solo 401K Plan to make an investment please contact a Solo 401K Expert at 800-472-0646.

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Sep 12

Using a Loan With a Self Directed 401K Plan to Make an Investment

When it comes to using retirement funds, such as a Self Directed 401K Plan, to make investments, the question arises whether a Self Directed 401K Plan can utilize a loan as part of the transaction.

The IRS has always allowed a Self Directed 401K, also known as a Solo 401K Plan, to make traditional as well as non-traditional investments such as real estate. However, the prohibited transaction rules under Internal Revenue Code Section 4975 restrict a Solo 401K Plan participant from engaging in certain transactions – prohibited transactions. Under IRC 4975, one of the categories of prohibited transactions involve a disqualified person personally guaranteeing a loan made to a Solo 401K Plan. A Solo 401K plan participant is treated as a disqualified person pursuant to IRC 4975. As a result, a Solo 401K cannot use a recourse loan to purchase property owned by a Plan because a disqualified person (Solo 401K Plan participant) cannot personally guarantee a loan. However, the IRS does allow for the 401K to use a nonrecourse loan to purchase real estate. A nonrecourse loan is a loan that does not require a personal guarantee on the part of the Solo 401K plan participant. In other words, a loan that would limit a lender’s (bank) ability to go after an individual personally for non-payment of the loan. Instead, the lender’s sole remedy would be to look to the underlying property as satisfaction of the loan. Of course, this type of loan is more difficult to acquire and can be more expensive for a borrower.

In general, Internal Revenue Code Section 514(c)(9) permits a few types of exempt organizations to make debt-financed investments in real property without becoming taxable under Code Section 514. Note – the exemption only applies to real estate and not to other types of nonrecourse financing, such as margin on stock.

Using a Loan With a Self Directed 401K Plan to Make an InvestmentThe Section 514 exemption applies to any “qualified organization,” a term that includes (1) schools, colleges, universities, and their “affiliated support organizations,” (2) qualified pension, profit sharing, and stock bonus trusts, and (3) title holding companies exempt under § 501(c)(25). In general, indebtedness incurred by a qualified organization in acquiring or improving real property is not acquisition indebtedness if the transaction navigates through a long list of prohibitions. In other words, a Solo 401K Plan can use nonrecourse leverage when purchasing real property with Plan assets and not be subject to the Unrelated Debt-Financed Income rules, which in-turn trigger an Unrelated Business Taxable Income (UBTI or UBIT) tax (approximately 40% for 2016). Note – only nonrecourse leverage can be used when acquiring property by a 401K or Solo 401K Plan since, a disqualified person (401(k) plan participant or trustee) cannot personally guarantee the loan (recourse loan) since that would violate the prohibited transaction rules pursuant to Internal Revenue Code Section 4975. It is important to remember that this exemption would not apply to an IRA since an IRA is not a qualified pension, profit sharing, and stock bonus trusts.

To satisfy the exemption under Internal Revenue Code Section 514, the price paid by the organization for the property or improvement must be fixed when the property is acquired or the improvement is completed, neither the amount nor the due date of any payment under the indebtedness can be contingent on the revenue, income, or profits from the property, and the property may not be leased to the person who sold the property to the organization or to any person related to the seller within the meaning of Code Section 267(b) or Code Section 707(b). If the organization is a qualified pension, profit sharing, or stock bonus trust, the property may not be purchased from or leased to the employer of any of the employees covered by the trust or any one of several persons related to the employer. Financing for the property may not be received from the person who sold the property to the organization, a person related to the seller within the meaning of Code Section 267(b) or Code Section 707(b), or, if the organization is a qualified employee trust, an employer or related person who is disqualified from being seller or lessee under the rule described in the preceding sentence. The property must usually be owned directly by the qualified organization, except that an interest in a partnership or other pass-through entity qualifies if all of the partners or other owners are qualified organizations and each partner or other owner is allocated the same distributive share of every item of partnership income, deduction, and credit.

When § 514(c)(9) was enacted in 1980, it applied only to qualified pension, profit sharing, and stock bonus plans, but its scope was broadened in 1984 to include schools, colleges, and universities.

Many people ask why this exemption only applies to 401K Plans and not IRAs. The only reason given in the committee reports for the exemption is that some people wanted it: “Trustees of these plans are desirous of investing in real estate for diversification and to offset inflation. Debt-financing is common in real estate investments.”  The provision was originally limited to qualified employee trusts on the theory that the income would eventually be taxed to employees and their beneficiaries.

To learn more about the rules surrounding using a loan with a Solo 401K Plan to make an investment please contact a Solo 401K Expert at 800-472-0646.

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Sep 01

The Solo 401k and UDFI

Am I subject to UBTI Tax on Unrelated Debt Financed Income in a Solo 401(k) Plan?

No. Unlike a Self Directed IRA LLC, when a Solo 401(k) Plan uses nonrecourse leverage to purchase real estate that is leveraged, it is exempt from paying any Unrelated Business Taxable Income (UBTI) tax on the income or gain generated.

When an IRA buys real estate that is leveraged with mortgage financing, it creates Unrelated Debt Financed Income (a type of Unrelated Business Taxable Income) on which taxes must be paid. A Solo 401(k) plan is exempt from UDFI pursuant to Internal Revenue Code Section 514(c)(9).

With the UBTI tax rates at approximately 40% for 2016, the Solo 401(k) Plan offers real estate investors looking to use nonrecourse leverage in a transaction with a tax efficient solution.

The Solo 401k and UDFI“Debt-financed property” refers to borrowing money to purchase the real estate (i.e., a leveraged asset that is held to produce income). In such cases, only the income attributable to the financed portion of the property is taxed; gain on the profit from the sale of the leveraged assets is also UDFI (unless the debt is paid off more than 12 months before the property is sold).

Why does this Exemption Apply to 401(k) Plans and Not IRAs?

When Internal Revenue Code Section 514(c)(9) was enacted in 1980, it applied only to qualified pension, profit sharing, and stock bonus plans, but its scope was broadened in 1984 to include schools, colleges, and universities. The provision brings the history of Internal Revenue Code Section 514 full circle by exempting some organizations, such as 401(k) Qualified Plan, from tax on income from the very sort of leveraged real estate deals that provoked the enactment of the predecessor of Internal Revenue Code Section 514 in 1950. As per the legislative history, the only reason given in the committee reports for the exemption is that some people wanted it: “Trustees of these plans are desirous of investing in real estate for diversification and to offset inflation. Debt-financing is common in real estate investments.”

Please contact one of our 401(k) Experts at 800-472-0646 for more information.

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May 17

How to Make an Investment with a Solo 401(k) Loan

When it comes to using retirement funds, such as a Solo 401K Plan, to make investments, the question arises whether a Solo 401K Plan can utilize a loan as part of the transaction.

The IRS has always allowed a Solo 401K Plan to make traditional as well as non-traditional investments such as real estate. However, the prohibited transaction rules under Internal Revenue Code Section 4975 restrict a Solo 401(k) Plan participant from engaging in certain transactions – prohibited transactions. Under IRC 4975, one of the categories of prohibited transactions involve a disqualified person personally guaranteeing a loan made to a Solo 401K Plan. A Solo 401K plan participant is treated as a disqualified person pursuant to IRC 4975. As a result, a Solo 401K, also known as an Individual 401K or Self Directed 401K Plan, cannot use a recourse loan to purchase property owned by a Plan because a disqualified person (Solo 401K Plan participant) cannot personally guarantee a loan. However, the IRS does allow for the 401K to use a nonrecourse loan to purchase real estate. A nonrecourse loan is a loan that does not require a personal guarantee on the part of the Solo 401K plan participant. In other words, a loan that would limit a lender’s (bank) ability to go after an individual personally for non-payment of the loan. Instead, the lender’s sole remedy would be to look to the underlying property as satisfaction of the loan. Of course, this type of loan is more difficult to acquire and can be more expensive for a borrower.

In general, Internal Revenue Code Section 514(c)(9) permits a few types of exempt organizations to make debt-financed investments in real property without becoming taxable under Code Section 514. Note – the exemption only applies to real estate and not to other types of nonrecourse financing, such as margin on stock.

How to Make an Investment with a Solo 401(k) LoanThe Section 514 exemption applies to any “qualified organization,” a term that includes (1) schools, colleges, universities, and their “affiliated support organizations,” (2) qualified pension, profit sharing, and stock bonus trusts, and (3) title holding companies exempt under § 501(c)(25). In general, indebtedness incurred by a qualified organization in acquiring or improving real property is not acquisition indebtedness if the transaction navigates through a long list of prohibitions. In other words, a Solo 401K Plan can use nonrecourse leverage when purchasing real property with Plan assets and not be subject to the Unrelated Debt-Financed Income rules, which in-turn trigger an Unrelated Business Taxable Income (UBTI or UBIT) tax (approximately 40% for 2016). Note – only nonrecourse leverage can be used when acquiring property by a 401K or Solo 401K Plan since, a disqualified person (401(k) plan participant or trustee) cannot personally guarantee the loan (recourse loan) since that would violate the prohibited transaction rules pursuant to Internal Revenue Code Section 4975. It is important to remember that this exemption would not apply to an IRA since an IRA is not a qualified pension, profit sharing, and stock bonus trusts.

To satisfy the exemption under Internal Revenue Code Section 514, the price paid by the organization for the property or improvement must be fixed when the property is acquired or the improvement is completed, neither the amount nor the due date of any payment under the indebtedness can be contingent on the revenue, income, or profits from the property, and the property may not be leased to the person who sold the property to the organization or to any person related to the seller within the meaning of Code Section 267(b) or Code Section 707(b). If the organization is a qualified pension, profit sharing, or stock bonus trust, the property may not be purchased from or leased to the employer of any of the employees covered by the trust or any one of several persons related to the employer. Financing for the property may not be received from the person who sold the property to the organization, a person related to the seller within the meaning of Code Section 267(b) or Code Section 707(b), or, if the organization is a qualified employee trust, an employer or related person who is disqualified from being seller or lessee under the rule described in the preceding sentence. The property must usually be owned directly by the qualified organization, except that an interest in a partnership or other pass-through entity qualifies if all of the partners or other owners are qualified organizations and each partner or other owner is allocated the same distributive share of every item of partnership income, deduction, and credit.

When § 514(c)(9) was enacted in 1980, it applied only to qualified pension, profit sharing, and stock bonus plans, but its scope was broadened in 1984 to include schools, colleges, and universities.

Many people ask why this exemption only applies to 401K Plans and not IRAs. The only reason given in the committee reports for the exemption is that some people wanted it: “Trustees of these plans are desirous of investing in real estate for diversification and to offset inflation. Debt-financing is common in real estate investments.”  The provision was originally limited to qualified employee trusts on the theory that the income would eventually be taxed to employees and their beneficiaries.

To learn more about the rules surrounding using a loan with a Solo 401K Plan to make an investment please contact a Solo 401K Expert at 800-472-0646.

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Feb 12

Is a Solo 401(k) Plan Subject to the Same UBTI Rules as a Self Directed IRA LLC?

Yes and No. Like an IRA, the tax advantage of a Solo 401K Plan is that income is tax-free until distributed. In general, an exempt organization is not taxed on its income from an activity that is substantially related to the charitable, educational, or other purpose that is the basis for the organization’s exemption. Such income is exempt even if the activity is a trade or business. However, to prevent tax-exempt entities from competing unfairly with taxable entities, tax-exempt entities are subject to unrelated business taxable income (UBTI) when their income is derived from any trade or business that is unrelated to its tax-exempt status.

What is Unrelated Business Taxable Income?

UBTI is defined as “gross income derived by any organization from any unrelated trade or business regularly carried on by it” reduced by deductions directly connected with the business. The UBTI rules only apply to exempt organizations such as charities, IRAs, and 401(k) Plans. Congress enacted the UBTI rules in the 1950s in order to prevent charities from competing with for-profit businesses since charities do not pay tax giving them an unfair advantage over for- profit businesses. With the enactment of ERISA in 1974, IRAs and 401(k), who are considered tax-exempt parties pursuant to Internal Revenue Code Sections 408 and 401 respectively, became subject to the UBTI rules. As a result, if an IRA or 401(k) invests in an active business through an LLC or partnership, the income generated by the IRA or 401(k) from the active business investment will be subject to the UBTI rules. In other words, a 401(k) Plan that is a limited partner, member of a LLC, or member of another non-corporate entity will have attributed to it the UBTI of the enterprise as if it were the direct recipient of its share of the entity’s income which would be UBTI had it carried on the business of the entity.   For example, if a Solo 401(k) Plan invests in an LLC that operates an active business such as a restaurant or gas station, the income or gains generated from the investment will generally be subject to the UBTI tax. However, if the Solo 401(k) Plan invested in an active business through a C corporation, there would be no UBTI since the C Corporation acts as a blocker blocking the income from flowing through to the Solo 401(k) Plan. This is why you can invest IRA and 401(k) funds into a public company, such as IBM without triggering the UBTI tax. Remember that if an IRA or 401(k) Plan makes a passive investment, such as rental income, dividends, and royalties, such income would not be subject to the UBTI rules.

UDFI and The Solo 401(k) Plan

However, unlike a Self-Directed IRA LLC, in the case of a Solo 401(k) Plan, UBTI does not apply to unrelated debt-financed income (UDFI). The UDFI rules apply when a 401(k) Plan uses leverage to acquire property such as real estate. Pursuant to Internal Revenue Code Section 514(c)(9), a 401(k) Qualified Plan is not subject to the UDFI rules and, thus, the UBTI tax if nonrecourse leverage is used to acquire property such as real estate. With the UBTI tax rates at approximately 40% for 2016, the Solo 401(k) Plan offers real estate investors looking to use nonrecourse leverage in a transaction with a tax efficient solution.

Exceptions to the UBTI Rules

There are some important exceptions from UBTI: those exclusions generally exclude the majority of income generating investment activities from the UBTI rules – dividends, interest, annuities, royalties, most rentals from real estate, and gains/losses from the sale of real estate.

Is a Solo 401(k) Plan subject to the same UBTI rules as a Self Directed IRA LLC?What is an Unrelated Business?

For a Solo 401(k), any business regularly carried on or by a partnership or corporation of which it is a member/partner is an unrelated business. For example, the operation of a shoe factory by a pension trusts, the operation of a financial consulting business for high net worth individuals by a university, or the operation of an computer rental business by a hospital would likely be treated as an unrelated business and subject to UBTI.

UBTI & Real Estate Investments

Although there is little formal guidance on UBTI implications for Solo 401(k) Plans investing in real estate, there is a great deal of guidance on UBTI implications for real estate transactions by tax-exempt entities. In general, Gains and losses on dispositions of property (including casualties and other involuntary dispositions) are excluded from UBTI unless the property is inventory or property held primarily for sale to customers in the ordinary course of an unrelated trade or business. This exclusion covers gains and losses on dispositions of property used in an unrelated trade or business, as long as the property was not held for sale to customers. In addition, subject to a number of conditions, if an exempt organization acquires real property or mortgages held by a financial institution in conservatorship or receivership, gains on dispositions of the property are excluded from UBTI, even if the property is held for sale to customers in the ordinary course of business. The purpose of the provision seems to be to allow an exempt organization to acquire a package of assets of an insolvent financial institution with assurance that parts of the package can be sold off without risk of the re-sales tainting the organization as a dealer and thus subjecting gains on re-sales to the UBIT.

How Do I Avoid UBTI?

In general, if you make passive investments with your Solo 401(k) Plan, such as stocks, mutual funds, precious metals, foreign currency, rental real estate, etc the passive income generated by the investment will generally not be subject to the UBTI tax. Only if your Solo 401(k) Plan will be making investments into an active business, such as a retail store, restaurant, software company using a passthrough entity such as an LLC or partnership will your Solo 401(k) Plan likely be subject to the UBTI tax.

Please contact one of our 401(k) Experts at 800-472-0646 for more information.

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