Important Questions to Ask When Selling Real Estate in Your IRA

Is the property an investment or business inventory?

The IRS will allow a tax-exempt organization (IRA or 401(k)) to engage in a passive activity that generates capital gains, interest, rental income, royalties, and dividends without incurring any tax (IRC 512). However, if the IRA/401(k) engages in an active trade or business, such as a restaurant, store, or manufacturing business, the IRS will tax the income from the business activity since the income is not deemed to relate to the entity’s exempt purpose. This tax is generally referred to as Unrelated Business Taxable Income (UBTI).

What type or level of activity relating to real estate transactions will trigger UBTI tax?

Unfortunately, there is no clear test as to how many houses can be sold or the number of real estate transactions one must engage in any given year in order to trigger the UBTI tax. The IRS has several factors it will review and examine to determine if UBTI is applicable:

  1. Volume and frequency of activity – how much buying and selling has been conducted?
  2. Intention – what was the intention of the IRA owner at the time of the purchase? Was it to hold and rent long term, as an investment, or was it to fix and flip as a business?
  3. What is the nature and scope of the other assets and activities performed in the IRA – is it part of a business or an investment?

The determination of whether an activity is an active trade or business depends on the facts and circumstances. If the examination results in UBTI, the tax quickly reaches a rate of approximately 35% and will be reported on IRS form 990T and paid by the IRA or 401(k). Many people feel it is not worth it if UBTI is triggered but it should be examined especially if one is already in the high income tax bracket. Therefore, it is important to work with a tax professional that can help one evaluate the transaction to determine whether the flipping transaction will trigger the UBTI or UBIT tax.

Examples when UBTI may apply:

  1. The intent when purchased was to fix and flip a house.
  2. 5 houses were bought, fixed up, and flipped and no other investments were made in the IRA.
  3. The IRA purchased a restaurant franchise with property and collected income from the business.
  4. The IRA buys 15 non-performing notes, turns them into performing notes, and sells them.
  5. The IRA buys furniture and appliances and rents it out to individuals or businesses.
  6. The IRA makes a down payment on a property and takes a non-recourse loan for the remainder of the sale price. Unrelated Debt Financed Income (UDFI) would apply (a subset of UBTI).

Examples of when UBTI may not apply:

  1. The IRA buys one house and rents it long term.
  2. The IRA buys 3 houses for long term rentals, makes 1 private  loan, buys 1 performing note, buys 100 tax liens, buys 50 oz of gold, and has to flip one of the three houses to fix an asbestos problem in the other 2 houses.
  3. Buys an interest in an apartment building without any debt.

For more information on purchasing real estate in your IRA, please visit our Investment Page.