Individual Retirement Accounts (IRAs) offer more flexibility than most people realize. Not only can they be used to invest in stocks, bonds, mutual funds, or exchange-traded funds (EFTs), they can also be used to invest in and buy real estate. These types of investments can range from single-family homes to commercial properties such as office buildings, raw land and more.
The challenge with these types of investments is that the tax complications and rules associated with these transactions are not straight-forwarded, and if not followed closely can result in large tax liabilities. While many use a self-directed Roth IRA to make these types of investments, the Malta Pension Plan is another option to consider, and has distinct tax advantages.
Investing in real estate requires the use of a self-directed IRA, and many choose to utilize a self-directed Roth IRA. This type of account has already had taxes withheld, so once the individual is eligible to make withdrawals (i.e. held the account for at least five years; and be at least 59 ½, die or become disabled) then the distributions are tax-free. These distributions also include any increase in value and revenue streams, to include the sale price and/or rent—which can certainly be advantageous.
With the Roth IRA, there is also no required minimum distribution (RMD) which means that the real estate investment does not need to be liquidated at age 70 ½ as would be required with a traditional IRA. Furthermore, contributions to the Roth IRA can be continued past age 70 ½, allowing for an extended revenue stream during retirement.
Many combine the aforementioned advantages of the self-directed Roth IRA with debt financing in order to increase their return on equity and investment. The challenge with this approach though is that investors may trigger Unrelated Business Taxable Income (UBTI) taxes if the investment is financed with a non-recourse loan, or is no longer considered a passive income stream.
The UBTI is intended to treat the IRA similar to a for-profit business when the IRA is engaging in active business activities, or is using leverage. This often occurs with real estate such as stores, manufacturing or restaurants because they are deemed to be actively trading or conducting business. UBTI would not be triggered for passive income though, such as rental income, dividends or royalties. Less clear is during house flipping, or multiple real estate transactions. The IRS examines the frequency and volume of the transactions to determine whether UBTI has been triggered.
If UBTI is triggered, net UBTI income will be taxed at the trust rate since an IRA is considered a trust for tax purposes, and not a corporation. This means that the top marginal tax bracket can be used at 39.6%, in addition to the additional layer of taxation applied for state tax purposes. When using debt-financing, tax is applied to the portion of the gain that is debt-financed.
A property is deemed to be debt-financed if at any time during the 12-month period before the date of disposition the property held by the IRA is disposed of at a gain during the tax year, and there was acquisition indebtedness outstanding for that property. Usually this equates to the average amount of the outstanding principal debt during the part of the tax year the property is held by the IRA. Both income and gains will be subject to taxation based upon the ratio of debt financing relative to the adjusted basis of the property, and any gains will also be subject to capital gains taxation.
It is easy to see how challenging it can be to avoid high levels of taxation utilizing the self-directed Roth IRA approach with debt financing to invest in real estate. Fortunately, the MPP provides an alternative. Since the MPP is a foreign grantor trust, the use of debt financing does not trigger UBTI requirements upon the plan. MPP administrators may typically restrict debt financing to 50% of the property value, but this limit is discretionary. This means that the investor can minimize concerns over triggering UBTI, particularly with real estate that could be seen as generating active income or business, or if there are frequent transactions involving the real estate that is financed.
Investing in real estate using investment accounts can have distinct advantages, but if investors aren’t careful, they could be cancelling out any gains they hoped to achieve by falling prey to steep tax liabilities. The MPP is an option that presents less tax risk, and helps to safeguard potential gains on real estate investments that are debt-financed. Another advantage of the MPP is that real estate sold by the MPP will defer capital gains and allow proceeds to be invested into any asset type or class. If the MPP participant is over the age of 50 they can receive tax free treatment on distribution therefore eliminating the tax of the sale of their appreciated asset that was held inside the MPP. Every real estate should at least consider this option and explore if it is a fit for their unique situation with expert tax planning MPP specialists.