December 16, 2015-January 5, 2016 —
COLORADO REAL ESTATE JOURNAL
— Page 23
Law & Accounting
M
any real estate inves-
tors have heard
about the benefits
of using self-directed individu-
al retirement accounts to fund
their latest ventures into the real
estate market. There are many
companies conducting seminars
and webinars that sell the inves-
tor on this idea. I know first-
hand because our office receives
the very same marketing mate-
rial. While the current state of
the law does seem to allow for
these transactions, unfortunately
many investors are not aware
of the limitations that the tax
code imposes on these types
of transactions. In this article
I’ll explore two considerations
every investor should be aware
of before using a self-directed
IRA to invest in real estate: 1)
prohibited transactions and 2)
unrelated business income tax.
n
The danger of prohibited
transactions.
To begin, I’d like
to share a quick word about the
danger and what’s at stake. The
tax code (specifically 26 USC §
4975) is written in such a way
that there are numerous “pro-
hibited transactions” in which
an IRA is simply not allowed
to engage. If an IRA moves for-
ward with one of these transac-
tions, the ramifications are enor-
mous. If you believe you may
be in danger of running afoul of
these rules (or maybe you think
you’ve already broken a rule),
then speak to your tax adviser
as quickly as possible to explore
your options and the full extent
of the penalties that you may
face. There are strategies to mini-
mize the impact, but it is critical
to be proactive and correct the
transaction quickly!
I won’t explore all of the rami-
fications here just to keep things
fairly simple, but the heart of
what the law does is that it
causes an investor’s IRA to lose
its IRA status. In other words,
the IRA simply ceases to be an
IRA on the first day of the tax-
able year in which the transac-
tion takes place. The IRA is treat-
ed as having distributed all of its
assets to the investor and there’s
the potential that the investor
will be hit with a large tax bill
as a result. Finally, penalties will
likely apply, further reducing
the investor’s retirement funds.
n
Trans-
actions to
avoid.
So
what transac-
tions, exactly,
are we talking
about? The
law is writ-
ten in general
terms to cast
a wide net.
If you are
thinking of
entering into
a transaction
and
aren’t
sure if you should, I cannot
stress enough the importance of
consulting with your tax adviser.
The law is generally written
to avoid self-dealing between
a “disqualified person” and
the IRA. A disqualified person
includes, among others, the fidu-
ciary in charge of the plan, any
individual providing services to
the plan, an employer whose
employees participate in the
plan, the person for whom the
IRA is established or a member
of that person’s family (spouse,
ancestor, lineal descendant or
spouse of a lineal descendant).
Specific examples of prohibited
transactions will include:
•Use of IRA income or assets
for a disqualified person’s own
benefit;
•Leveraging or using IRA
assets as security for a loan (non-
recourse loans are allowed);
•The
following
actions
between the IRA and a disquali-
fied person:
° Selling, exchanging or leas-
ing property;
° Lending money or extending
credit;
° Furnishings, goods, services
or facilities;
° The outright transfer of IRA
income or assets to the disquali-
fied person.
n
Unrelated business
income tax.
IRAs are unique
and they benefit greatly from
their preferential tax treatment.
Interest groups were concerned
that an IRA conducting business
activities would have an unfair
advantage and regular business-
es would not be able to compete.
Because of this concern, Con-
gress drafted a special tax into
the tax code called Unrelated
Business Income Tax.
Unrelated business income is
simply income derived from a
trade or business that is regular-
ly carried on and is not substan-
tially related to the tax-exempt
purpose of the IRA. In the real
estate context, a very common
example of IRA transactions that
generate UBIT is leveraging a
rental property with a nonre-
course loan. When this occurs,
a portion of the income received
in rents (and possibly on the
sale of the property) is subject
to UBIT.
UBIT, however, is not the end
of the world and a little context
is necessary here. First, if your
IRAis subject to UBIT, that really
means that your investment is
paying off. In other words, the
investment in your IRA is gen-
erating profit and that means
that your retirement account is
growing. Next, the IRAwill sim-
ply prepare and file a tax return
(Form 990-T) and pay any tax
that may be due. UBIT is not
nearly as important of a concern
as the prohibited transaction
because it doesn’t carry the same
consequences, but inmy practice
I’ve found that not many inves-
tors who are considering the use
of the IRA to invest in real estate
are even aware of the tax.
n
Wrapping it up.
To bring
this to a close, as a tax profes-
sional I have met with many
established and new clients who
would like to take advantage of
the funds in their IRA to begin
tapping the real estate market
and grow their retirement nest
egg. I understand the tempta-
tion, especially here in Denver.
Time and again, I advise my
clients of the important limita-
tions found in the tax code and
ensure that they do not run afoul
of any of these arguably lesser-
known corners of the regulatory
framework surrounding IRAs. If
you are a real estate investor, my
final bit of advice is to choose
your advisers carefully and
ensure that you surround your-
self with a knowledgeable team
that can advise you concerning
the many aspects of a particular
investing strategy. Doing so will
help ensure your continued suc-
cess in this rewarding and fast-
paced market.
s
Peter McFarland
Associate attorney,
Estill & Long LLC,
Denver
