The Internal Revenue Code (“IRC”) does not describe what a retirement plan can invest in, only what it cannot invest in. Internal Revenue Code Sections 408 & 4975 prohibits Disqualified Persons from engaging in certain type of transactions. The purpose of these rules is to encourage the use of retirement accounts for accumulation of retirement savings and to prohibit those in control of the retirement account from taking advantage of the tax benefits for their personal account.
With the rough start to 2016 for the world stock markets, alternative asset investments, such as real estate, have become more attractive to many retirement account holders. However, what many retirement account investors are not aware of is that hidden in the tax code is a noteworthy provision that allows a 401(k) plan to purchase real estate with leverage without triggering a tax. Let me explain further.
In general, when it comes to using a retirement account to make investments, most are exempt from federal income tax. This is because a retirement account is exempt from tax pursuant to IRC Sections 401 and 408. IRC Section 512 of the Internal Revenue Codes exempt most forms of investment income generated by an IRA from taxation. Some examples of the exempt type of income include: interest from loans, dividends, annuities, royalties, most rentals from real estate, and gains/losses from the sale of real estate. Whereas, the type of income that generally could subject a retirement account to UBTI is income generated from the following sources:
• Income from the operations of an active trade or business – i.e. a restaurant, gas station, store, etc.
• Business income generated via a passthrough entity, such as an LLC or partnership
• Using a nonrecourse loan to purchase a property (in the case of an IRA)
• Using margin on a stock purchase
These rules can be found under Internal Revenue Code Sections 511-514 and have become known as the Unrelated Business Taxable Income rules or UBTI or UBIT. If the UBTI rules are triggered, the income generated from that activities would generally be subject to close to a 40% tax for 2016. The UBTI rules apply to both IRA and 401(k) plans, however, there is one unique exemption found under IRC 514(c)(9) which would allow a 401(k) plan investment to purchase real estate and use nonrecourse leverage without triggering tax.