The Tax Cuts and Jobs Act – the sweeping series of Tax Cuts Congress passed at the tail end of December 2017 – included a bit of Christmas cheer for dedicated Self-Directed IRA investors.
Normally, as most readers are aware, there are no current year tax consequences for dividends, rental income or capital gains as long as the money remains within a Self-Directed IRA of any type. The income or gains continue to grow tax-deferred, or in the case of Self-Directed Roth IRA accounts, tax-free (as long as it stays in the account at least five years).
But that tax benefit does not apply to income or capital gains that are attributed to borrowed money. Instead, a special tax on what is called UBTI (Unrelated Business Taxable Income) applies.
You see, you only get the tax advantage on your own invested money – not on money you borrow from other people!
So, if you have 45 percent equity in a given property within a Self-Directed Real Estate IRA and you have a mortgage covering the other 55 percent, then 55 percent of your income from the property, and 55 percent of any capital gains from that property are federally taxable – at a punitive maximum rate of 37 percent!
The same principle applies to stocks and other securities in a Self-Directed IRA that are bought using a margin loan, and in certain cases, investing in an active business or trade via an LLC or other pass-through entity, such as a limited partnership. (S-corporations are pass-through entities, of course, but you cannot own them within a Self-Directed IRA, so they do not apply to this discussion).
Some Self-Directed IRA investors try to limit the impact of taxes on UDFI (Unrelated Debt Financed Income Tax) by creating a C corporation, and then using the C corporation to make the investments. It is a tax planning tool called a C corporation blocker.
Here is how it works: C corporations benefit a great deal from the Tax Cuts and Jobs Act, which reduces the corporate income tax rate from 35 percent to 21 percent. The corporation itself releases the dividends to the retirement account, rather than to the taxpayer directly, and they do not come from the property itself.
Obviously, there is a big difference between a 21 percent tax rate and a 37 percent rate, or even the old maximum income tax marginal rate of 35 percent.
Meanwhile, the real estate or other leveraged investment does not pay its income and gains directly to the Self-Directed IRA. Instead, they go to the C corporation.
When set up correctly, this is a big improvement compared to paying the marginal rate on your personal income tax returns, which is where your unrelated business income tax would wind up.
American IRA, LLC does not provide individualized tax advice. The information in this article is for general informational purposes only and should not be construed to be tax advice in your individual case. Readers should engage the services of a qualified tax professional, such as a CPA or enrolled agent before taking action.
Interested in learning more about Self-Directed IRAs? Contact American IRA, LLC at 866-7500-IRA (472) for a free consultation. Or visit us online at www.AmericanIRA.com.