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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Aug 22

Is a Solo 401k Subjected to the Same UBTI Rules as a Self-Directed IRA?

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.

Is a Solo 401k Subjected to the Same UBTI Rules as a Self-Directed IRA?UDFI and The Solo 401k 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 2017, 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.

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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Aug 04

The Advantages of the Roth Solo 401(k) Plan

The Roth Solo 401(k) Plan is the ultimate tax-free retirement solution for the self-employed. With federal and state income tax rates expected to increase in the future, gaining the ability to generate tax-free returns from your retirement investments when you retire is the last surviving legal tax shelter. With a Roth Solo 401K you can make almost any investment tax-free, including real estate, tax liens, precious metals, currencies, options, and private business investments.  Once you hit the age of 59 1/2 you will be able to live off your Roth 401K assets without ever paying tax. Imagine if someone told you that if you started making Roth 401K contributions in your forties and by just generating a modest rate of return, you could have over a million dollars tax-free when you retire. With a Roth 401K, live off the Roth 401K investment income tax-free or take a portion of your Roth 401K funds and use it for any purpose without ever paying tax.

The Roth Solo 401(k) Plan Advantages

Power of Tax-Free Investing: One of the main attractions to the self-directed Roth Solo 401(k) plan is based on the fact that qualified distributions of Roth earnings are tax-free. As long as certain conditions are met and the distribution is a qualified distribution, the Roth solo 401(k) plan participant will never pay tax on any Roth distributions received. The advantage of contributing to a Roth solo 401(k) plan is that income and gains generated by the Roth 401(k) investment can be tax-free and penalty-free so long as certain requirements are satisfied. Unlike with a pre-tax solo 401(k) plan contributions, contributions to a Roth solo 401(k) are not tax deductible.

 

The power of tax-free investing can be best illustrated by way of the following examples:

Example 1: Joe, a self-employThe Roth Solo 401(k) Plan is the ultimate tax-free retirement solution for the self-employed.ed consultant began funding a Roth solo 401(k) plan with $3,000 per year at age 20 and would continue on through age 65. At age 65 Joe would wind up with $2.5 million at retirement (assuming they earn the long-run annual compound growth rate in stocks, which was 9.88 percent from 1926 to 2011). Not a bad result for investing only $3,000 a year.

Example 2: Ben, a self-employed real estate agent, who is 30 years began funding a Roth solo 401(k) plan with $8000 and wanted to know how much he would have at age 70 if he continued to make $8000 annual contributions and was able to earn at an 8% rate of return. Ben did some research and was astonished that at age 70 he would have a whopping $ 2,238,248 tax-free which he can then live off or pass to his wife or children tax-free.

Example 3: Mary, a self-employed real estate investor, who is 35 years began funding a Roth solo 401(k) plan with $13000 and wanted to know how much she would have at age 70 if she continued to make $13000 annual contributions and was able to earn at a 10% rate of return, which she felt was possible based off her past real estate investment returns. Mary did some research and was astonished that at age 70 she would have a whopping $ 3,875,649 tax-free which she could then live off or pass to her husband and children tax-free.

I am sure it may be hard for some of you to comprehend that putting away just a few thousand dollars a year in a Roth Solo 401(k) plan can leave you with millions of dollars tax-free. It’s as simple as making annual contributions to your Roth Solo 401(k) Plan and then generating tax-free returns from making real estate or other investments with your solo 401(k) plan.

High Contributions: A Roth Solo 401(k) combines features of the traditional 401(k) with those of the Roth IRA. Like a Solo 401K Plan, the Roth Solo 401K Plan is perfect for any self-employed individual or small business owner with no employees. The Roth Solo 401K Plan contains the same advantages of a Solo 401(k) Plan, but as with a Roth IRA, contributions are made with after-tax dollars. While you don’t get an upfront tax-deduction, the Roth 401K account grows tax-free, and withdrawals taken during retirement aren’t subject to income tax, provided you’re at least 59 1/2 and you’ve held the account for five years or more.

The Roth Solo 401(k) can offer advantages to self-employed individuals who wish to maximize their ability to generate tax-free retirement savings while receiving the ability to invest in real estate, precious metals, private businesses or funds tax-free and without custodian consent.

Unlike a Roth IRA, which limits individual Roth IRA contributions to $5,500 annually ($6,500 if the individual is 50 years or older), in 2017, with a Roth Solo 401(k) account, an individual can make Roth (after-tax) contributions of up to $18,000, or $24,000 for those 50 or older by the end of the year — allowing individuals to stock away thousands of dollars more in tax-free retirement income than they would through a Roth IRA.

A Roth Solo 401(k) is perfect for sole proprietors, small businesses and independent contractors such as consultants. The Roth Solo 401(k) plan is unique and so popular because it is considered the last remaining legal tax shelter available. There are so many features of the Roth Solo 401(k) plan that make it so appealing and popular among self-employed business owners.

Unlimited Investment Opportunities: With a Roth 401(k) Plan or Roth 401(k) plan sub-account, you can invest your after-tax Roth 401(k) Plan funds in real estate, precious metals, tax liens, private business investments, and much more tax-free! Unlike with a pre-tax 401(k) Plan, with a Roth 401(k) account, all income and gains would flow back tax-free to your account. As long as you have reached the age of 59 1/2 and have had the Roth 401(k) account opened at least five years, you can take Roth 401(k) Plan distributions tax-free. In other words, you can live off your Roth 401(k) Plan assets or income tax-free. With federal income tax rates expected increase, the ability to have a tax-free source of income upon retirement may be the difference between retiring early or not.

Loan Feature: While an IRA offers no participant loan feature, the Roth Solo 401k allows participants to borrow up to $50,000 or 50% of their account value (whichever is less) for any purpose at a low interest rate (the lowest interest rate is Prime which is 4.25% as of 6/23/17). This offers a Roth Solo 401(k) Plan participant the ability to access up to $50,000 to use for any purpose, including paying personal debt or funding a business.

Offset the Cost of Your Plan with a Tax Deduction: By paying for your Solo 401(k) with business funds, you would be eligible to claim a deduction for the cost of the plan, including annual maintenance fees. The deduction for the cost associated with the Solo 401(k) Plan and ongoing maintenance will help reduce your business’s income tax liability, which will in-turn offset the cost of adopting a self-directed Solo 401(k) Plan. The retirement tax professionals at the IRA Financial Group will help you take advantage of the available business tax deduction for adopting a Solo 401(k) Plan.

Cost Effective Administration: In general, the Roth solo 401(k) plan is easy to operate. There is generally no annual filing requirement unless your solo 401(k) plan exceeds $250,000 in assets, in which case you will need to file a short information return with the IRS (Form 5500-EZ).

Exemption from UDFI: When an IRA buys real estate that is leveraged with mortgage financing, it creates Unrelated Debt Financed Income (“UDFI”) – a type of Unrelated Business Taxable Income (also known as “UBTI” or “UBIT”) on which taxes must be paid. The UBTI tax is approximately 40% for 2017. Whereas, with a Roth Solo 401(k) plan, you can use leverage without being subject to the UDFI rules and UBTI tax. This exemption provides significant tax advantages for using a Roth Solo 401(k) Plan versus an IRA to purchase real estate.

To learn more about the Roth Solo 401(k) Plan, please contact a 401(k) 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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Jul 28

Take Control of Your Retirement with a Checkbook Control Solo 401(k)

With a Solo 401(k) Plan, as trustee of the Plan, you no longer have to get each 401(k) Plan investment approved by the custodian of your account. This means that all assets of the 401(k) trust are under the sole authority of the Solo 401k Plan participant (you).  A Solo 401(k) plan allows you to eliminate the expense and delays associated with an IRA custodian, enabling you to act quickly when the right investment opportunity presents itself.

Take Control of Your Retirement with a Checkbook Control Solo 401(k)For example, Mary has established a Solo 401(k) Plan for her business. Mary is appointed the trustee of her business’s Solo 401(k) Plan. Mary has opened her Solo 401(k) Plan bank account at a local bank. Mary wishes to use her 401(k) Plan funds to purchase a home from Ben, an unrelated third-party (non-disqualified person). Ben is anxious to close the transaction as soon as possible. With a Solo 401(k) Plan, Mary, as trustee of the Plan, can simply write a check using the funds from the 401(k) Plan bank account or can wire the funds directly from the account to Ben. Mary, as trustee of the Plan, no longer needs to seek the consent of the custodian or a financial institution before making the real estate purchase. With a Solo 401(k) Plan without “checkbook control”, Mary would likely not be able to make the real estate purchase since seeking custodian approval would have likely taken too much time.

Investment Opportunities

With a Solo 401(k) Plan, you will be able to invest in almost any type of investment opportunity that you discover, including: Real Estate (rentals, foreclosures, raw land, tax liens etc.), Private Businesses, Precious Metals, Hard Money & Peer to Peer Lending as well as stock and mutual funds; you’re only limit is your imagination. The income and gains from these investments will flow back into your 401(k) Plan tax-free.

The following are some examples of types of investments that can be made with your Solo 401(k) Plan:

  • Residential or commercial real estate
  • Domestic or Foreign real estate
  • Raw land
  • Foreclosure property
  • Mortgages
  • Mortgage pools
  • Deeds
  • Private loans
  • Tax liens
  • Private businesses
  • Limited Liability Companies
  • Limited Liability Partnerships
  • Private placements
  • Precious metals and certain coins
  • Stocks, bonds, mutual funds
  • Foreign currencies

Real Estate

The IRS has always permitted a 401(k) Plan to purchase or hold real estate or raw land. Making a real estate investment is as simple as writing a check. Since you are the trustee of your Solo 401(k) Plan, you have the authority to make investment decisions on behalf of your 401(k) Plan. One major advantage of purchasing real estate with a Solo 401(k) Plan is that all gains are tax-deferred until a distribution is taken.

For example, if you purchased a piece of property with your Solo 401(k) Plan for $200,000 and later sold the property for $400,000, the $200,000 of gain would generally be tax-free. Whereas, if you purchased the property using personal funds (non-retirement funds), the gain would be subject to federal income taxes and in most cases state income tax.

Using Leverage to Purchase Real Estate with a Solo 401(k) Plan

Unlike a Self Directed IRA LLC, when a Solo 401(k) Plan buys real estate that is leveraged with mortgage financing it is exempt from paying any Unrelated Business Taxable Income (UBTI or UBIT) tax on the income or gain generated. With the UBTI tax rates at approximately 35%, the Solo 401(k) Plan offers real estate investors looking to use nonrecourse financing in a transaction a tax efficient solution.

Tax Liens

By using a Solo 401(k) Plan to purchase tax-liens or tax deeds, all income and profits are tax-deferred back into your Solo 401(k) Plan until a distribution is taken. More importantly, with a Solo 401(k) Plan, you, as the trustee, will have “checkbook control” over your 401(k) Plan funds allowing you to make purchases on the spot without custodian consent. In other words, purchasing a tax-lien or tax deed is as easy as writing a check!

Loans & Notes

The IRS and ERISA rules permit the use of Solo 401(k) Plan funds to make loans or purchase notes from third parties. By using a Solo 401(k) Plan to make loans or purchase notes from third parties, all interest payments received would be tax-deferred until a distribution is taken.

For example, if you used a Solo 401(k) Plan to loan money to a friend, all interest received would flow back into your Solo 401(k) Plan tax-free. Whereas, if you lent your friend money from personal funds (non-retirement funds), the interest received would be subject to federal and in most cases state income tax.

Private Businesses

With a Solo 401(k) you are permitted to purchase an interest in a privately held business. The business can be established as any entity other than an S Corporation (i.e. limited liability company, C Corporation, partnership, etc.). When investing in a private business using Solo 401(k) Plan funds, it is important to keep in mind the “Disqualified Person” and “Prohibited Transaction” rules under IRC 4975 and the Unrelated Business Taxable Income rules under IRC 512.

Investing in an Active Business – The Unrelated Business Taxable Income Rules

If a Solo 401(k) invests in any business regularly carried on or by a partnership or LLC of which it is a member, all income or gains allocated to the Solo 401(k) will likely be treated as an unrelated business and subject to the Unrelated Business Taxable Income (“UBTI” or “UBIT”) rules pursuant to Section 512 of the Internal Revenue Code. For example, a Solo 401(k) investment into an LLC or partnership that is engaged in an active trade or business such a shoe factory; gas station, retail store or restaurant would likely be treated as an unrelated business and subject to UBTI.

The UBTI rules were enacted by Congress in the 1950s t o prevent tax-exempt entities, such as charities, from competing unfairly with taxable entities. Since an 401(k) is treated as a tax-exempt entity pursuant to Internal Revenue Code Section 401, the UBTI rules apply to Solo 401(k) investments.

Most 401(k) investments are not subject to the UBTI rules because of the many exceptions available. For example, dividends, interest, annuities, royalties, capital gains, most rentals from real estate, and gains/losses from the sale of real estate are all excluded from the application of the UBTI tax. However, rental income generated from real estate that is “debt financed” loses the exclusion, and that portion of the income becomes subject to UBTI.

A Solo 401(k) subject to UBTI is taxed at the trust tax rate because a 401(k) is considered a trust pursuant to Internal Revenue Code Section 401. For 2011, a Solo 401(k) subject to UBTI is taxed at the following rates:

  • $0 – $2,300 = 15%
  • $2,300 – $5,350 = $345 + 25%
  • $5,350 – $8,200 = $1,107.50 + 28%
  • $8200 – $11,200 = $1,905.50 + 33%
  • Over $11,200 = $2,895.50 + 35%

Precious Metals & Coins

A Solo 401(k) Plan is permitted to invest in certain platinum coins as well as certain gold, silver, platinum, or palladium bullion provided the coins are held in a financial organization.

The advantages of using a Solo 401(k) Plan with “checkbook control” to purchase precious metals and/or coins is that their values generally keep up with, or exceed, inflation rates better than other investments. In addition, the metals and/or coins can be held in the name of the 401(k) Plan at a financial organization (at any local bank) safety deposit box eliminating depository fees.

Foreign Currencies

The IRS does not prevent the use of 401(k) funds to purchase foreign currencies, including Iraqi Dinars. Many believe that foreign currency investments offer liquidity advantages to the stock market as well as significant investment opportunities.

Purchasing foreign currency, such as the Iraqi Dinar, with a Solo 401(k) Plan is as easy as writing a check. As trustee of the Solo 401(k) Plan, you will have “checkbook control” over your 401(k) Plan funds, providing you with the ability to make investments without requiring custodian consent. In addition, the foreign currency notes, including Iraqi Dinars, can be held in the name of the 401(k) Plan at a financial organization (any local bank) safety deposit box eliminating depository fees.

By using a Solo 401(k) Plan to purchase foreign currencies, such as the Iraqi Dinar, all foreign currency gains generated would be tax-deferred until a distribution is taken. In the case of a Solo 401(k) Plan, all foreign currency gains would be tax-free.

Stocks, Bonds, Mutual Funds, CDs

In addition to non-traditional investments such as real estate, a Solo 401(k) Plan may purchase stock, bonds, mutual funds, and CDs. The advantage of using a Solo 401(k) Plan with “checkbook control” is that you are not limited to just making these types of investments. With a Solo 401(k) Plan with “checkbook control” you can open a stock trading account with any financial institution as well as purchase real estate, buy tax liens, or lend money to a third-party. Your investment opportunities are endless!

What Types of Investments are Not Permitted Using a Solo 401(k) Plan?

The Internal Revenue Code does not describe what an IRA can invest in, only what it cannot invest in. Internal Revenue Code Section 4975 prohibits Disqualified Persons from engaging in certain type of transactions. The purpose of these rules is to encourage the use of 401(k) funds for accumulation of retirement savings and to prohibit those in control of retirement funds from taking advantage of the tax benefits for their personal account.

Who is a “Disqualified Person”?

The IRS has restricted certain transactions between the Solo 401(k) Plan and a “disqualified person”. The rationale behind these rules was a congressional assumption that certain transactions between certain parties are inherently suspicious and should be disallowed.

The definition of a Disqualified Person (Internal Revenue Code Section 4975(e)(2)) extends into a variety of related party scenarios, but generally includes the 401(k) Plan participant, any ancestors or lineal descendants of the 401(k) Plan participant, and entities in which the 401(k) Plan participant holds a controlling equity or management interest. In essence, under Code Section 4975, a “Disqualified Person” means:

  • A fiduciary (e.g., the 401(k) Plan participant, or person having authority over making 401(k) Plan investments),
  • A person providing services to the plan (e.g., the trustee or custodian),
  • An employer, any of whose employees are covered by the 401(k) Plan,
  • An employee organization any of whose members are covered by the 401(k) Plan,
  • A 50 percent owner of C or D above,
  • A family member of A, B, C, or D above (family members include the fiduciary’s spouse, parents, grandparents, children, grandchildren, spouses of the fiduciary’s children and grandchildren (but not parents-in-law),
  • An entity (corporation, partnership, trust or estate) owned or controlled more than 50 percent by A, B, C, D, or E. Whether an entity is a disqualified person is determined by considering the indirect stockholdings/interest which would be taken into account under Code Sec. 267(c), except that members of a fiduciary’s family are the family members under Code Sec. 4975(e)(6) (lineal descendants) for purposes of determining disqualified persons.
  • A 10 percent owner, officer, director, or highly compensated employee of C, D, E, or G,
  • A 10 percent or more partner or joint venturer of a person described in C, D, E, or G.

Note: brothers, sisters, aunts, uncles, cousins, step-brothers, step-sisters, and friends are NOT treated as “Disqualified Persons”.

Prohibited Transactions

Solo 401(k) prohibited transactions are listed in Code Section 4975; prohibited transactions are any direct or indirect:

  • Sale or exchange, or leasing, of any property between a plan and a disqualified person;
  • Lending of money or other extension of credit between a plan and a disqualified person;
  • Furnishing of goods, services, or facilities between a plan and a disqualified person;
  • Transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan;
  • Act by a disqualified person who is a fiduciary whereby he deals with the income or assets of a plan in his own interests or for his own account; or
  • Receipt of any consideration for his own personal account by any disqualified person who is a fiduciary from any party dealing with the plan in connection with a transaction involving the income or assets of the plan.

Examples of Prohibited Transactions

The following are a number of common Solo 401(k) Plan related transactions that are prohibited pursuant to Internal Revenue Code Section 4975:

  • Selling interest in real estate to a Disqualified Person
  • Selling or transferring real estate you own personally to your Solo 401(k) Plan
  • Purchasing real estate with Solo 401(k) funds and leasing to a disqualified person
  • Investing 401(k) funds in a house that is used by the 401(k) owner (or other Disqualified Person)
  • Using the Solo 401(k) Plan as security for a loan
  • Personally guaranteeing a loan to your Solo 401(k) Plan
  • Buying real estate with your Solo 401(k) Plan and making repairs personally or having a “Disqualified Person” make repairs
  • Buying real estate with personal funds and then transferring title to the Solo 401(k)
  • Using personal funds to pay taxes and expenses related to the Solo 401(k) Plan real estate investment
  • Being compensated for any services performed for or on behalf of the Solo 401(k) Plan
  • Contributing personal funds to your 401(k) Plan bank account
  • Acquiring a credit card for your Solo 401(k) Plan bank account
  • Using your retirement funds to make a real estate investment and earning a commission personally from the purchase
  • Making an investment using your 401(k) Plan into a company or fund that will benefit the 401(k) Plan participant or a Disqualified Person personally
  • Making an investment using Solo 401(k) funds to facilitate or protect the 401(k) owner’s investment
  • The Solo 401(k) invests in a business owned by the Solo 401(k) Plan participant who serves as the 401(k) Plan trustee and the 401(k) Plan participant owner generates a salary from the business
  • Solo 401(k) Plan participant, as trustee of the Solo 401(k) Plan, using 401(k) Plan funds to lend money to an entity which he/she has an interest in
  • Engaging in a transaction whereby the Solo 401(k) Plan participant – serving as trustee of the 401(k) Plan – independent judgment is affected
  • Purchasing company stock from the Solo 401(k) Plan participant whereby the purchase helps the Solo 401(k) Plan owner personally
  • Investing in a company owned by the Solo 401(k) Plan participant who is the trustee of the Solo 401(k) Plan whereby the investments benefits the Solo 401(k) Plan participant personally

Tax-Free Gains

With a Solo 401(k) Plan “Checkbook Control” structure, all income and gains from investments will generally flow back to your 401(k) Plan tax-free. Because a 401(k) Plan is treated as a tax-exempt entity pursuant to Internal Revenue Code Section 401, all income and gains generated by the 401(k) Plan will flow-through to the 401(k) Plan account tax-free!

For additional information on the advantages of using a Solo 401(k) Plan with “checkbook control” to make investments, please contact one of our 401K Experts at 800-472-0646.

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Jul 07

How to Use a Solo 401k Plan to Invest in Options

When it comes to making investments with a Solo 401(k) Plan, the IRS generally does not tell you what you can invest in, only what you cannot invest in. The types of investments that are not permitted to be made using retirement funds is outlined in Internal Revenue Code Section 408 and 4975. These rules are generally known as the “Prohibited Transaction” rules.

In addition to the Prohibited Transaction rules, the IRS imposes a levy or tax on certain transactions involving IRA funds. In general, when one uses IRA funds to invest in an active business, such as a restaurant, store, factory that is operated through a passthrough entity such as a Limited Liability Company or Partnership or used nonrecourse financing, such as a nonrecourse loan or margin in a stock or trading account, a percentage of net profits or income generated by that activity could be subject to a tax. The tax imposed is often referred to as Unrelated Business Taxable Income or UBIT or UBTI. The UBTI rules are generally outlined in Internal Revenue Code Sections 512-514.

How to Use a Solo 401k Plan to Invest in OptionsThe reason the UBTI tax rules do not impact most retirement investors, is that Internal Revenue Code Section 512(b) provides a general exemption for the following categories of income generated by a retirement account: dividends, interest, royalties, rental income, and capital gain type transaction, As a result, since the majority of retirement investors purchase publicly traded company stock, which is exempted from the UBTI tax pursuant to Internal Revenue Code Section 512, the UBTI tax rules are not widely known.

When it comes to investing in options with a Solo 401(k) Plan the question then becomes whether the investment would trigger the UBTI rules. An option is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date. An option, just like a stock or bond, is a security. It is also a binding contract with strictly defined terms and properties.

According to the IRS , any gain from the lapse or termination of options to buy or sell securities is excluded from unrelated business taxable income. Note – the exclusion is not available if the organization is engaged in the trade or business of writing options or the options are held by the organization as inventory or for sale to customers in the ordinary course of a trade or business. Hence, if option trading is not being done as an active trade or business, then using a Solo 401(k) Plan to invest in options would not trigger the UBTI tax rules.

For more information on using a solo 401(k) Plan to invest in options, please contact a tax professional at 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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Jun 17

What Are the Advantages of a Solo 401k Plan vs a Self-Directed IRA?

A Solo 401(k) Plan is an IRS approved retirement plan, which is suited for business owners who do not have any employees other than themselves and perhaps their spouse. The “one-participant 401(k) Plan” or individual 401(k) Plan is not a new type of plan. It is a traditional 401k Plan covering only one employee.  Unlike a Traditional IRA, which only allows an individual to contribute $5500 annually or $6500 if the individual is over the age of 50, a Solo 401k Plan offers the Plan participant the ability to contribute up to $60,000 each year.  Before the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) became effective in 2002, there was no compelling reason for an owner-only business to establish a Solo 401(k) Plan because the business owner could generally receive the same benefits by adopting a profit sharing plan or a SEP IRA.  After 2002, EGTRRA paved the way for an owner-only business to put more money aside for retirement and to operate a more cost-effective retirement plan than a Traditional IRA or 401(k) Plan.

There are a number of options that are specific to Solo 401k Plans that make the Solo 401k Plan a far more attractive retirement option for a self-employed individual than a Traditional IRA for a self-employed individual.

1. Reach your Maximum Contribution Amount Quicker: A Solo 401(k) Plan includes both an employee and profit sharing contribution option, whereas, a Traditional IRA has a very low annual contribution limit.

Under the 2017 Solo 401(k) contribution rules, a plan participant under the age of 50 can make a maximum employee deferral contribution in the amount of $18,000. That amount can be made in pre-tax or after-tax (Roth). On the profit sharing side, the business can make a 25% (20% in the case of a sole proprietorship or single member LLC) profit sharing contribution up to a combined maximum, including the employee deferral, of $54,000.

What Are the Advantages of a Solo 401k Plan vs a Self-Directed IRA?For plan participants over the age of 50, an individual can make a maximum employee deferral contribution in the amount of $24,000. That amount can be made in pre-tax or after-tax (Roth). On the profit sharing side, the business can make a 25% (20% in the case of a sole proprietorship or single member LLC) profit sharing contribution up to a combined maximum, including the employee deferral, of $60,000.

Whereas, a Traditional Self-Directed IRA would only allow an individual with earned income during the year to contribute up to $5500, $6500 if the individual is over the age of 50.

For example, Joe, who is 60 years old, owns 100% of an S Corporation with no full time employees.  Joe earned $100,000 in self-employment W-2 wages for 2017.  If Joe had a Solo 401(k) Plan established for 2017, Joe would be able to defer approximately $49,000 for 2017 (a $24,000 employee deferral, which could be pre-tax or Roth, and 25% of his compensation giving him $49,000 for the year).   Whereas, if Joe established a Traditional Self-Directed IRA, Joe would only be able to defer approximately $6,500 for 2017.

2. No Roth Feature: A Solo 401k Plan can be made in pre-tax or Roth (after-tax) format.  Whereas, in the case of a Traditional Self-Directed IRA, contributions can only be made in pre-tax format.  In addition, a contribution of $18,000 ($24,00, if the plan participant is over the age of 50) can be made to a Solo 401(k) Roth account.

3. Tax-Free Loan Option: With a Solo 401K Plan, you can borrow up to $50,000 or 50% of your account value, what ever is less.  The loan can be used for any purpose.  With a Traditional Self-Directed IRA, the IRA holder is not permitted to borrow even $1 dollar from the IRA without triggering a prohibited transaction.

4. Use Nonrecourse Leverage and Pay No Tax: With a Solo 401(k) Plan, you can make a real estate investment using nonrecourse funds without triggering the Unrelated Debt Financed Income Rules and the Unrelated Business Taxable Income (UBTI or UBIT) tax (IRC 514).  However, the nonrecourse leverage exception found in IRC 514 is only applicable to 401(k) qualified retirement plans and does not apply to IRAs. In other words, using a Self-Directed SEP IRA to make a real estate investment (Self Directed Real Estate IRA) involving nonrecourse financing would trigger the UBTI tax.

5. Open the Account at Any Local Bank: With a Solo 401k Plan, the 401k bank account can be opened at any local bank or trust company.  However, in the case of a Traditional Self Directed IRA, a special IRA custodian is required to hold the IRA funds.

6. No Need for the Cost of an LLC: With a Solo 401(k) Plan, the plan itself can make real estate and other investments without the need for an LLC, which, depending on the state of formation, could prove costly. Since a 401(k) Plan is a trust, the trustee on behalf of the trust can take title to a real estate asset without the need for an LLC.

7. Better Creditor Protection: In general, a Solo 401(k) Plan offers greater creditor protection than a Traditional IRA.  The 2005 Bankruptcy Act generally protects all 401(k) Plan assets from creditor attack in a bankruptcy proceeding.  In addition, most states offer greater creditor protection to a Solo 401(k) qualified retirement plan than a Traditional Self-Directed IRA outside of bankruptcy.

The Solo 401k plan is unique and so popular because it is designed explicitly for small, owner-only business.  The many features of the Solo 401k plan discussed above is why the Solo 401k Plan or Individual 401k Plan it so appealing and popular among self-employed business owners.

To learn more about the benefits of a Solo 401(k) Plan vs. a Self-Directed IRA, please contact a tax professional at 800-472-0646.

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Jun 14

Using Your Self-Directed Solo 401k Plan to Invest in Real Estate

Most people mistakenly believe that their 401(k) must be invested in bank CDs, the stock market, or mutual funds. Few Investors realize that the IRS has always permitted real estate to be held inside 401(k) retirement accounts. Investments in real estate with an Individual 401(k), also known as a Solo 401(k), are fully permissible under the Employee Retirement Income Security Act of 1974 (ERISA). IRS rules permit you to engage in almost any type of real estate investment, aside generally from any investment involving a disqualified person.

Advantages of Using a Solo 401(k) to Purchase Real Estate

Income or gains generated by a 401(k) Plan generate tax-deferred/tax-free profits. Using a Solo 401(k) Plan to purchase real estate allows Using a Solo 401(k) To Purchase Real Estatethe 401(k) to earn tax-free income/gains and pay taxes at a future date, rather than in the year the investment produces income.

With a Solo 401(k), you can invest tax-free and not have to pay taxes right away – or in most cases for many years allowing your retirement funds to grow tax-free! All the income or gains from your real estate deals flow though to your 401(k) account tax-free!

Types of Real Estate Investments

Below is a partial list of domestic or foreign real estate-related investments that you can make with a Solo 401(k):

  • Raw land
  • Residential homes
  • Commercial property
  • Apartments
  • Duplexes
  • Condos/townhomes
  • Mobile homes
  • Real estate notes
  • Real estate purchase options
  • Tax liens certificates
  • Tax deeds

Investing in Real Estate with a Solo 401(k) is Quick & Easy!

Purchasing real estate with a Solo 401(k) Plan is essentially the same as purchasing real estate personally.

  • Set-up a Solo 401(k) Plan with the IRA Financial Group.
  • Identify the investment property.
  • Purchase the investment property with the Solo 401(k) Plan – no need to seek the consent of the custodian with a Solo 401(k) Plan since you serve as Trustee and Plan Administrator.
  • Title to the investment property and all transaction documents should be in the name of the Solo 401(k) Plan. Documents pertaining to the property investment must be signed by you as Trustee.
  • All expenses paid from the investment property go through the Solo 401(k) Plan. Likewise, all rental income checks must be deposited directly in to the Solo 401(k) Plan bank account. No 401(k) related investment checks should be deposited into your personal accounts.
  • All income or gains from the investment flow through to your 401(k) tax-free!

Solo 401K Solution

Structuring the Purchase of Real Estate with a Solo 401(k) Plan

When using a Solo 401(k) to make a real estate investment there are a number of ways you can structure the transaction:

1. Use your Solo 401(k) funds to make 100% of the investment

If you have enough funds in your Solo 401(k) to cover the entire real estate purchase, including closing costs, taxes, fees, insurance, you may make the purchase outright using your Solo 401(k). All ongoing expenses relating to the real estate investment must be paid out of your Solo 401(k) bank account. In addition, all income or gains relating to your real estate investment must be returned to your Solo 401(k) bank account.

2. Partner with Family, Friends, Colleagues

If you don’t have sufficient funds in your Solo 401(k) to make a real estate purchase outright, your Solo 401(k) can purchase an interest in the property along with a family member (non-disqualified person), friend, or colleague. The investment would not be made into an entity owned by the 401(k) owner, but instead would be invested directly into the property.

For example, your Solo 401(k) Plan could partner with a family member, friend, or colleague to purchase a piece of property for $150,000. Your Solo 401(k) Plan could purchase an interest in the property (i.e. 50% for $75,000) and your family member, friend, or colleague could purchase the remaining interest (i.e. 50% for $75,000).

All income or gain from the property would be allocated to the parties in relation to their percentage of ownership in the property. Likewise, all property expenses must be paid in relation to the parties’ percentage of ownership in the property. Based on the above example, for a $2,000 property tax bill, the Solo 401(k) would be responsible for 50% of the bill ($1000) and the family member, friend, or colleague would be responsible for the remaining $1000 (50%).

Isn’t Partnering with a family member in a Real Estate Transaction a Prohibited Transaction?

Likely not if the transaction is structured correctly. Investing in an investment entity with a family member and investing in an investment property directly are two different transaction structures that impact whether the transaction will be prohibited under Code Section 4975. The different tax treatment is based on who currently owns the investment. Using a Solo 401(k) Plan to invest in an entity that is owned by a family member who is a disqualified person will likely be treated as a prohibited transaction. However, partnering with a family member that is a non-disqualified person directly into an investment property would likely not be a prohibited transaction. Note: If you, a family member, or other disqualified person already owns a property, then investing in that property with your Solo 401(k) would be prohibited.

3. Borrow Money for your Solo 401(k)

You may obtain financing through a loan or mortgage to finance a real estate purchase using a Solo 401(k). Solo 401(k) participants can also borrow up to either $50,000 or 50% of their account value – whichever is less to help finance a real estate investment.

If using financing through a third-party loan to purchase real estate (other than a loan from the 401(k) Plan), one important point must be considered when selecting this option:

  • Loan must be non-recourse – A “prohibited transaction” is a transaction that, directly or indirectly involves the loan of money or other extension of credit between a plan and a disqualified person. Normally, when an individual purchases real estate with a mortgage, the traditional loan provides for recourse against the borrower (i.e., personal liability for the mortgage). However, if the 401(k) Plan purchases real estate and secures a mortgage for the purchase, the loan must be non-recourse; otherwise there will be a prohibited transaction. A non-recourse loan only uses the property for collateral. In the event of default, the lender can collect only the property and cannot go after the 401(k) Plan itself.

Note: Unlike a Self-Directed IRA LLC, pursuant to Internal Revenue Code Section 514(c)(9), in the case of a Solo 401(k) Plan, the Unrelated Business Income Tax (UBTI) does not apply when using nonrecourse leverage as part of a real estate transaction (unrelated debt-financed income – UDFI). Therefore, unlike a Self-Directed IRA LLC, using a Solo 401K to finance a real estate investment will not trigger UBTI – which imposes a tax in the range of 40% for 2017 on all income/gains relating to the debt financed portion of the investment.

To learn more about using a Solo 401(k) Plan to invest in real estate, please contact one of our Solo 401(k) Plan Experts at 800-472-0646 for more information.

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Jun 01

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

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) Is a Solo 401(k) Plan Subject to the Same UBTI Rules as a Self Directed IRA?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 2017, 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.

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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