Over the years I have seen a number of articles regarding investment in real estate by trustees of traditional and Roth IRAs. On the surface, investment is real estate, a long term investment, makes a lot of sense within a retirement vehicle which is itself long-term. The devil is always in the details. The tax rules regarding unrelated business taxable income (UBTI) make investment in real estate difficult as most real estate investment involves some level of debt-financing. On a more practical level, the contribution limits also make real estate investment difficult. The likely scenario where real estate investment within a traditional or Roth IRA makes sense is within a traditional or Roth IRA with rollover funds or funded by a lump sum distribution from a qualified retirement plan.
This article focuses on the use of Malta Pension Plans as an alternative to the traditional and Roth IRAs as a vehicle for long-term investment in real estate and wealth accumulation. As the article will demonstrate, the Malta Pension Plan has many attributes which make it more advantageous for real estate investment that the traditional and Roth IRAs. The primary advantages focus on more favorable contribution limits and the absence and the lack of UBTI treatment for Malta Pension Plans. Frankly, after these points, there isn’t more convincing to do. Nevertheless, the article lays out the benefits of the Malta Pension Plan for real estate investment.
Roth IRA Overview
According to the Investment Company Institute (ICI), Americans held $7.9 trillion in individual retirement accounts (IRAs) at year-end 2016, with Roth IRAs accounting for $660 billion of that total. Forty-seven percent of IRA assets, or $3.7 trillion, were invested in mutual funds. The second most common type is the Roth IRA, created by the Taxpayer Relief Act of 1997. Sixty-nine percent of IRA investors in 2015 owned traditional IRAs and 34 percent owned Roth IRAs.
A few trust companies such as Pensco and Entrust specialize in self-directed IRA (traditional or Roth) with non-traditional assets. Nevertheless, the IRA rules limit do not permit investment in life insurance, collectibles or foreign investments with the exception of American Depository Receipts (ADRs)
Another significant limitation is the imposition is the limitation on permissible investments. Roth IRAs are unable to make foreign investments or purchase life insurance. Roth IRAs cannot own collectibles. Traditional and Roth IRAs face the imposition of unrelated business taxable income (UBTI) for real estate investments subject to debt financing. UBTI will subject a pro rata portion of the real estate income to taxation within the Roth IRA. Business income owned within the Roth IRA will also be subject to UBTI treatment. As a result, Roth investments will tend to be limited to passive investment assets.
One of the major limitations regarding the Roth IRA is eligibility for the Roth IRA. A taxpayer that files jointly is able to contribute to a Roth IRA if the taxpayer’s modified adjusted gross income (AGI) does not exceed $173,000. The contribution phases out between $189,000-198,999. The contribution limit is only $5,500. Individuals age 50 and over can contribute up to $1,000 extra per year to “catch up” for a total of $6,500. A non-working spouse can open a Roth IRA based on the working spouse’s earnings.
Contributions to the Roth IRA must be made in cash. The prohibited transaction guidelines applicable to the traditional IRA. The unrelated business taxable income (UBTI) (UBTI) rules also apply to Roth IRAs. The combination of the prohibited transaction and UBTI rules limit the ability of the taxpayer to own the taxpayer’s business interests within the Roth IRA.
The primary difference between the Roth IRA and IRA or qualified plan is that the Roth IRA does not have required minimum distributions. Distributions from the Roth IRA are not subject to income taxation. However, the distribution from the Roth IRA must be a “qualified” distribution. Qualified distributions require five years of “seasoning” within the plan unless the taxpayer is at least age 59 ½.
Distributions before age 59 ½ are subject to a 10 percent early withdrawal penalty as well as normal tax treatment on the distribution (as if it were a traditional IRA). Like the IRA, exceptions to these rules exist for a distribution for a first-time home buyer; distribution to a disabled taxpayer, or a distribution to a beneficiary on account of the taxpayer’s death.
The account balance is included in the taxpayer’s taxable estate. At death, the remaining distribution of the account is subject to the same rules as the traditional IRA. A surviving spouse as the beneficiary of the Roth IRA can treat the Roth IRA as her own.
Real Estate Investment in Traditional and Roth IRAs
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. 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. It is a good idea to increase the return on equity and investment but a bad idea tax-wise. The problem is unrelated business taxable income (UBTI) created by the debt financing.
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.
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. It also applies to pension plans and IRAs. 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.
Overview of Malta Pension Schemes (MPP)
The Malta Pension Scheme in many respects is a surrogate to the Roth IRA. A taxpayer can make an unlimited contribution to the Malta Pension Scheme. Unlike the Roth IRA, the taxpayer may make in kind contributions to the MPP through the contribution of the asset or an interest in an entity holding the asset.
The MPP is treated as a grantor trust from a federal perspective. As a result, the contribution of an appreciated asset will not trigger any tax consequences on the transfer of an asset. As a result, of the foreign grantor status treatment, the MPP will avoid UBTI treatment of debt financed real estate and business income within the MPP. This is significant advantage in favor of the MPP over the Roth or traditional IRA.
Malta law permits distributions to be made from such plans as early as age 50.The rules allow an initial lump sum payment of up to 30% of the value of the member’s pension fund to be made free of Maltese tax. Based on treaty provisions, distributions that are non-taxable for Malta tax purposes are also non-taxable in the United States. Under Malta law, three years must pass after the initial lump sum distribution before additional lump sum distributions could be made to a resident of Malta tax-free. In Year 4, the MPP may distribute additional funds to the participant without triggering a tax liability. Lump sum distributions may be made every year after the second lump sum distribution each year. Fifty percent of the distribution is tax-exempt, and fifty percent is taxable.
Annual distributions may be taken beginning at age 50 and are taxed under IRC Sec 72 for U.S. purposes. Part of each distribution is treated as a return of principal and part of each payment is treated as ordinary income or capital gains depending upon the underlying asset.
U.S. Tax Compliance Requirements
Participation in the MPP requires compliance with the FinCEN reporting requirements for foreign bank and financial accounts. FinCEN Form 114 (Report of Foreign Bank and Financial Accounts) must be filed annually with the Financial Crimes Enforcement Network (FinCEN), a bureau of the Department of the Treasury.
Code Section 6038D, also enacted as part of FATCA, requires that any individual who holds any interest in a “specified foreign financial asset” must disclose such asset if the aggregate value of all such assets exceeds $50,000 (or such higher dollar amounts as may be prescribed).
IRS Form 8938 is used to report specified foreign financial assets if the total value of all the specified foreign financial assets in which you have an interest is more than the appropriate reporting threshold. As a foreign grantor trust, the taxpayer will most likely be required to file Form 3520.
The Malta Pension Plan is a powerful vehicle designed to provide for substantial tax deferral in a manner similar to the Roth IRA. The MPP advantage with respect to real estate investment is much greater due to the ability to use debt-financing without subjecting the plan to the UBTI rules. The MPP has no contribution limits. The taxpayer may contribute real estate assets. At distribution a substantial portion of the deferred income may be distributed without taxation in Malta or the United States. Taxpayers looking for a long-term tax deferral without contribution limitations and complicated tax hurdles such as UBTI, should consider the MPP as a planning structure for real estate investments.