Tax Issues & Consequences
Operating Losses are not deductible against other taxable income. IRA's are not currently taxable on their earnings. IRC § 408(e)(1). Thus, operating losses generated by a real estate investment will not be deductible against other income of the taxpayer.
Capital Gain Planning:
No capital gain planning can be done with real estate assets owned by a self-directed IRA. All
distributions are taxed at ordinary income tax rates. Currently, the difference between capital gain
rates, 0%, 5%, and 15% and ordinary income rates of 10%, 15% and 35%, is a 10% gap on the
lowest rates and a 20% gap on the highest rates.
Capital losses on the sale of real estate assets can never be recouped against other capital
gains or against taxable income.
Tax exempt or tax deferred transactions. Tax exempt and tax deferred transactions available for individuals, partnerships and corporations are unavailable for the self-directed IRA's. These include unlimited access to capital, sources of capital and contributions of capital, the ability to borrow without tax consequences, distribution of loan proceeds to the investor, partnership distributions, mergers, acquisitions, exchanges, swaps, bringing in new investors or allowing investors to exit on tax advantageous grounds.
Loss of control over the timing and amount of taxable income. Once the investor reaches the age of distribution, 70 1/2 years, the investor is required to receive a portion of the outstanding value of the IRA annually until death.
Liquidation on death. The entire value of the IRA is subject to income tax and estate tax upon death. Currently, the maximum rate is 35% for income tax and 50% for estate tax, reflecting a maximum tax of 85% before state taxes. The cumulative effect is the substantial liquidation of the IRA at death.
Gifting. Annual gifting, whether reported or not, is the primary method of passing wealth to heirs in the U.S. It is estimated that roughly 80% of family wealth is transferred via gift and estate tax transfers. Gift transfer of real estate is not possible with assets owned by self-directed IRA's. As discussed above, self-directed assets passing through estates are substantially eliminated with the combination estate and income taxes. If the assets are below the estate tax exemption, they must generally be sold immediately to pay the income taxes on the IRA, leading to diminished proceeds due to the short time frame for paying income taxes for the last tax year of the decedent.
UBTI. While earnings in an individual retirement account generally are exempt from tax, real estate, professionals and certain real estate investments held as inventory, property held for sale in the ordinary course of a trade or business (Section 512(b)) cause taxable income referred to as "unrelated business taxable income" (UBTI). Section 408(e)(1).
Example: By agreement, individual R's IRA becomes a partner in a partnership. The partnership
is a dealer in real property, generating income from the purchase and sale of real property in the
ordinary course of business. The IRA's share of this income is UBTI subject to tax. Such income is
taxable as ordinary income at the trusts and estate tax rate, payable by the IRA. Section 511(b)(1).
From a practical standpoint, the IRA would need its own checking account to pay for such taxes.
Paying the tax.
If an IRA generates gross income from an unrelated trade or business of more than $1,000,
it must file Form 990-T. An IRA owner must aggregate all of his or her individual accounts to
determine if the $1,000 threshold is met.
In order to file the form it is necessary for the IRA to obtain an Employer Identification
Number using Form SS-4. Form 990-T is due on or before the 15th day of the fourth
month following the close of the taxable year (April 15th for a calendar year IRA.)
Failure to file Form 990-T for other than reasonable cause may subject the trust to a
penalty of 5% per month of the net amount due, up to a maximum of 25%.
6651(a)(1); Regs. §301.6651(b) . The penalty applies only if there is an unpaid tax.
6651(b); Regs. §301.6651(b) . See also § 6651(c)(1), regarding the coordination of
this penalty with the penalty for failure to pay any taxes due.
UBTI is a difficult for many trustees and custodians of self-directed IRA's, who do not
receive the information needed for computing the tax. Many IRA trust and custodial
agreements place the responsibility for filing Form 990-T and the quarterly estimated
taxes on the IRA owner, although the instructions to Form 990-T state that the fiduciary
of trust is responsible for filing the return.
An IRA subject to unrelated business income tax must make quarterly estimated tax
payments, just as corporations do. The estimated tax is computed using Form 990-W.
(Form 990-W is a worksheet only and is not filed with the IRS) and must be deposited
by electronic funds transfer (EFT) for deposits made after December 31, 2010.
Use of leverage in the purchase of real estate in an IRA results in the taxation of the income from the real estate investment by the IRA. 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; gains on the profit from the sale of the leveraged assets also are UDFI (unless the debt is paid off more than 12 months before the property is sold.) Section 514(b). This income is taxed at the trust rate. IRC § 511(b)(1).
Example: If a IRA owner self directs the investment of $100,000 of IRA assets in real estate
which is debt financed with a $50,000 mortgage, only 50% of the rental income from the property
is subject to UBTI. The UBTI must be paid by the IRA, not the IRA owner, and therefore there
must be sufficient cash flow within the IRA.
In order to qualify for the rental UBTI exclusion, it is critical to ascertaining whether the transaction
has a different character (e.g., lease, loan, partnership). This is a question of facts and
circumstances. A transaction may state that payments are rental payments when in fact they
represent a share of the profits derived by the person operating the property.
The IRS has been successful in recharacterizing loan arrangements between a joint venture and a
purported "lender" and the taxpayer, to a real estate venture arrangement between the exempt
organization and the builder for rental income. 1.512(b)-1.
Rents attributable to personal property leased with real property should not exceed 10% of the
total rents from all property subject to the lease.
Thus, mortgage loans with "equity kicker" features (i.e., the borrower agrees to pay contingent
interest based on a share of the potential appreciation in, or cash flow from, the real estate
secured by the mortgage) are subject to IRS challenges that the debtor-creditor relationship
between lender and borrower should be treated as a disguised joint venture.
Tax Deferral. Depreciation deductions are not available to self-directed IRA in reducing the net taxable income for the real estate investor, thus one of the primary benefits of owning real estate is not available to the investor.
Tax Credits. Investments eligible for tax credits may not be used to offset the tax liability of the investor.
Utilizing Tax Losses. Real estate losses in excess of income can offset other taxable income reducing the investor's tax liabilities, subject to the rules below. Losses suspended may be carried forward and offset taxable income in the future upon sale or when the income exceeds deductions.
Dealer status. If the self-directed IRA is treated as a dealer or in the trade or business of owning, operating and managing investment real estate, the income is subject to UBTI (above).
Forgiveness or elimination of discharge of indebtedness income is only available to individual taxpayers, not trusts.