American taxpayers have approximately $4.7 trillion invested in IRAs as of 2011. Only 2 percent of these assets or $94 billion are invested in self-directed IRAs. This is a surprising result when you consider that after 2008, the average taxpayer has little or no confidence in the volatile stock market.
A Self directed IRA or Roth IRA provides the taxpayer with the ability to customize the investment options within the account. The account is administered by an independent trustee that allows for open architecture within the investment account. These companies are trust companies that are not in the investment business.
These asset classes can vary dramatically from the IRA or Roth IRA with Fidelity or Putnam. The range of investment can vary from Secured and unsecured private loans, real estate (except the house that you are living in!), foreign currencies, precious metals, tax lien certificates, private equity and closely held stock to name a few.
Nationally the commercial and residential real estate market continues to be very sluggish and except for a few key markets, isn't showing strong signs of improvement anytime soon in my opinion. National banks remain in the trigger hairs of litigation attorneys for their role in Robo-Signing among other crimes. Foreclosure defense attorneys in many jurisdictions are succeeding in foreclosure defense over "Who owns the Note" arguments. Homeowners who lost their homes in foreclosure are being compensated.
The bottom line is that it is still an attractive market to buy real estate at a large discount, make renovations and flip the property for a quick gain. Many of these investments will be purchases and "flips" that will be treated as a short term capital gains. As a result, funds within a regular IRA may be rolled over to a new self-directed IRA or a Roth IRA and used to purchase residential or commercial real estate for investment purposes.
In many cases, the investor may want to leverage the investment using debt financing. Good idea to increase the return on equity and investment but bad idea tax-wise. This financing strategy can cause a problem with Unrelated Business Taxable Income (UBTI).
The same concept applies when the self-directed IRA or Roth IRA invests in a private company that is structured as a pass-through entity - LLC or partnership. The business operating income of the private company will also be treated as UBTI.
The net UBTI income will be taxed as UBTI at the trust tax rate because an IRA is considered a trust for tax purposes and not a corporation. The top marginal tax bracket for trusts for federal tax purposes is 39.6 percent which is applicable at $11,950 of trust income. If you aren't already beginning to think twice, add another layer of taxation for state tax purposes. Pretty soon, you can have a tax disaster on your hands.
An effective way to combat UBTI treatment is using a private placement variable deferred annuity contract. Annuity income is not subject to UBTI tax treatment and is non-taxable to the IRA.
This article will outline how a PPVA contract can be used to eliminate the UBTI taint on investments that would otherwise create a tax problem. Large institutional investors have used this strategy for years. The limitation for individual investors has been the minimum premium threshold necessary to purchase a PPVA contract.
The minimum premium varies by carrier but generally has been in the $500,000- $2 million range for most life insurers - onshore or offshore. Needless to say, these limits would eliminate most investors. However, new options are available at much lower limits.
A. What is Unrelated Business Taxable Income (“UBTI”)?
UBTI is defined in IRC Sec. 512. as income from a “trade or business” that is regularly carried on by the tax-exempt organization but which is not substantially related to the exempt organization’s exempt purpose or function. Congress instituted this tax to prevent tax-exempt organizations from having an unfair advantage over taxable organizations.
UBTI is a concern to pension plans and IRAs because it converts income that would otherwise be treated as tax-exempt income into taxable income. UBTI includes income from debt-financed property using loans.
When debt is used by an IRA or pension plan, tax is applied to that portion of the gain that is debt-financed. Any property held to produce income is debt-financed property if at any time during the tax year there was acquisition indebtedness outstanding for the property.
When any property held for the production of income by an IRA is disposed of at a gain during the tax year, and there was acquisition indebtedness outstanding for that property at any time during the 12-month period before the date of disposition, the property is debt-financed property.
In general, average acquisition indebtedness for any tax year is the average amount of the outstanding principal debt during the part of the tax year the property is held by the entity or IRA.
Both income and gains will be subject to taxation in the property based upon the ratio of debt financing relative to the adjusted basis of the property. Any gains will be subject to capital gains taxation.
IRC Sec. 512(b)(1) specifically exempts annuity income from UBTI treatment along with other notable categories of income such as dividends,interest, capital gains, and rents. The PPVA contract converts UBTI income into annuity income which is exempt from UBTI treatment.
B. Private Placement Variable Deferred Annuities (PPVA)
PPVA is a private placement variable deferred annuity (PPVA) contract issued by a U.S. life insurance company or an offshore life insurer that has made an IRC Sec 953(d) election to be treated as a U.S. taxpayer. The PPVA contract is institutionally priced and transparent allowing for complete customization of the investment menu to include multiple real estate investments. The policy may be issued on either a group or individual policy form.
Under state insurance law, separate account investments are expressly authorized on a non-guaranteed or variable basis. The separate account assets belong to and are titled in the name of the insurance company.
Separate account contract holders have no right to receive in kind distributions, or direct the purchase or sale of separate account assets. Ownership and control of separate account assets legally and contractually rest with the insurer. PPVA contracts are taxed as a variable deferred annuity under the appropriate provisions of the Internal Revenue Code (IRC Sec 72).
C. Tax Qualification for Variable Annuities
Policies must satisfy the federal tax requirements for investment diversification and investor control.
The separate account is not treated as a separate entity from the insurance company for tax purposes. IRC Sec. 817(h) imposes investment diversification requirements for variable life insurance and annuity policies. IRC Sec. 817(h) stipulates that a single investment may not exceed more than 55% of the account value, two investments more than 70%, three investments more than 80%, and four
investments more than 90%. Therefore, an investment account must hold at least five different investments.
Importantly, pension annuity contracts as defined in IRC Sec 818(a) are exempt from the investment diversification rules. IRAs and Roth IRAs as well as other qualified plan arrangements under covered under IRC Sec 818(a). The bottom line is pension annuity contracts are exempt from the investment diversification requirements of IRC Sec 817(h). A pension annuity can have a single investment and meet the diversification requirements.
The other significant component for U.S. tax qualification is the Investor Control Doctrine. The Investor Control Doctrine has been developed as a series of rulings and court cases. Under the traditional variable annuity or life contract, the insurer and not the policyholder is considered the owner of the underlying separate account assets.
The policyholder is not taxed on the increase in the contract’s account value. However, if the insurer gives the policyholder a degree of control over investments underlying the contract that is inconsistent with treatment of the insurer’s status as owner of the assets, the tax benefits of the policy will be forfeited. Investor control is determined based upon the facts of a specific situation.
The investor control doctrine is still an important consideration for pension annuity contracts. The consequence of violating the investor control rules in a pension annuity contract is not the loss of tax deferral but rather the loss of tax treatment as an annuity contract for UBTI purposes. The problem can be managed.
D. The Mechanics for Purchasing Real Estate within a Self-Directed IRA
The steps for using a self-directed IRA or Roth IRA to purchase residential or commercial real estate are unique. In the first place, you need to have a self-directed IRA. In case you don't, you need to complete a trustee-to-trustee rollover of IRA funds. A sixty day rollover with payment directly can be made allowing the taxpayer 60 days to fund the new self-directed IRA.
In order to purchase real estate within a self directed IRA, the trustee of the IRA is the applicant, owner and beneficiary of the PPVA contract. The contract will feature a customized real estate insurance dedicated fund (IDF). The IDF is formed as a LLC. If multiple transactions are being contemplated, a series LLC may be used using a new series for each separate property being held within the annuity contract.
The insurance company appoints an independent investment advisor that may be recommended by the taxpayer. The reason for this is the consideration of the investor control doctrine. This investment advisor has the legal and investment discretion to buy or sell the property within the IDF. The life insurer subscribes to the Real Estate IDF. All of the income and gains flow through for the benefit of PPVA policyholder - the self-directed IRA.
The investment advisor may appoint a management company to manage the property. While it may be "cutting it a little close the vest" for investor control purposes, the advisor may hire a property management company managed by the taxpayer's spouse, business partner or siblings. As previously mentioned, the PPVA contract does not need to meet the diversification requirements for variable insurance contracts.
The manager of the real estate IDF completes and retains possession of all of the typical real estate documentation
(1) Settlement statement (signed by the managing member of the IDF)
(2) Preliminary Owners' Title Report (less than three months old)
(3) Copy of the conveyance deed (proposed)
(4) Contract or Purchase Agreement (signed by the managing member of the IDF)
(5) Property Management Agreement
(7) If the managing member has arranged financing for IRA PPVA IDF to purchase this property, promissory note (non-recourse note only), deed of trust/mortgage, and an amortization schedule (payment schedule)
You may be asking yourself if all of this is worth the "brain damage" in order to avoid UBTI tax treatment. The PPVA solution is an elegant solution that allows a taxpayer to convert all of the real estate debt finance income which is UBTI for tax purposes into tax-free income. The cost of the annuity contract is minimal compared to the top tax bracket for trusts - 39.6 -50 percent.
The ability to use debt financing allows the taxpayer to leverage the investment opportunity by using his IRA "equity" to purchase additional properties with the IRA account. Unlike the investment in the stock market, the taxpayer can drive by the real estate he owns within the IRA each day on his way to work. All of the income and gains, will be tax-deferred with the IRA.
PPVA contracts have been under-utilized as vehicles for investment in U.S. real estate within IRAs, Roth IRAs, Sep-IRAs, and Solo(k)s and small business pension plans. UBTI has been the biggest obstacle for many as many investors need to use debt financing in order to make the acquisition. The PPVA contract is a complete solution to the UBTI problem. Simply put, debt financed real estate income is converted into annuity income which is exempt from UBTI tax treatment. Options exist within the private placement insurance marketplace to accommodate the smaller transaction of an IRA or Roth IRA.
Many taxpayers have idle capital within their IRA that is seeking a higher and less volatile return. In many parts of the country, many opportunities exist to "buy low and sell high" when it comes to buying and flipping real estate. It is even better when there are no tax consequences to consider.