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A little clarity for your next decision.
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Investor WorkspaceA little clarity for your next decision.
By Jerry Baker
A self-directed IRA may invest in a Delaware statutory trust, or DST, if the custodian and offering allow it. The main issues are the investment's risks, possible tax from debt, account rules, and access to cash. Buying a DST with IRA cash is different from using personal property-sale proceeds in a 1031 exchange.
“Retirement money” can mean several things. It might mean savings in a regular brokerage account, a traditional IRA, a Roth IRA, or an employer plan. These accounts do not follow the same rules. Before discussing a property, I want to know which account would sign the subscription and provide the money.
A self-directed IRA is still an IRA. The term generally describes an account whose custodian permits a wider range of assets, such as private securities or real estate. It does not create a new tax exemption or waive normal IRA rules. The SEC warns that these investments can involve limited information, illiquidity, and fraud risk. [1]
Not every custodian will hold every DST. Not every offering accepts IRA investors. Confirm both before moving funds. Ask who will hold title, sign documents, receive cash, and supply the information needed for tax reporting.
This guide focuses on individual retirement accounts. An employer's 401(k), an inherited account, or another retirement arrangement can have different restrictions. Do not apply an IRA answer to one of those plans without checking its rules.
A person completing a 1031 exchange uses proceeds from qualifying real estate to acquire qualifying replacement real estate. Revenue Ruling 2004-86 explains how a DST interest can receive that treatment under the ruling's specific facts. It does not approve every trust or every transaction. [2]
When an IRA uses account cash to buy a DST, it is making a purchase. That purchase alone does not start the 45-day or 180-day exchange clocks. It also does not create a need to match debt from a property you sold in your own name.
Your IRA also does not need a 1031 exchange merely because it sold publicly traded investments to raise cash. Traditional IRA earnings and gains generally are not taxed to the owner until distributed, subject to exceptions discussed below. Its tax treatment already differs from a personally owned rental. [3]
Keep the two sources of money separate. A personal exchange and an IRA investment in the same offering would require separate ownership and careful review. Do not blend the checks or assume one account can satisfy the other's obligations.
What if the IRA already owns real estate with debt? Have a tax adviser review a planned sale or exchange. Those facts differ from buying a DST with account cash. One answer does not cover every deal an IRA might make.
The word “distribution” can refer to two different events. First, a DST may send a cash payment to the IRA that owns the interest. Second, the IRA custodian may distribute cash or property from the account to you. Track each event separately.
Suppose an IRA invests $200,000 and the DST later sends it $9,000. That deposit is account cash. It has not automatically become $9,000 of spendable income in your personal checking account. To use it personally, you would request an IRA distribution and follow the rules for that account.
Taxable withdrawals from a traditional IRA generally count as ordinary income. If you put in money without a deduction, that creates tax basis in the IRA. It can make part of a withdrawal tax-free. The IRA rules decide that amount. Owning real estate does not give the withdrawal a special capital-gain rate. [3]
Qualified Roth IRA withdrawals are tax-free. A withdrawal must meet the applicable requirements; “Roth” is not a promise that every withdrawal at any age is free of tax or penalties. Ask your tax adviser to review the account's history, holding rules, and your circumstances.
Likewise, depreciation inside an IRA investment is not a rental deduction that you simply place on your personal return. Where it affects tax inside the IRA, separate rules apply. Keep the property's tax figures distinct from your own IRA contribution basis and withdrawal calculations.
An IRA's usual tax advantages have exceptions. One is unrelated business income tax, commonly called UBIT. Income from certain business activities can be taxable within the account. Debt-financed property can also produce taxable income under these rules. IRS Publication 598 specifically includes traditional and Roth IRAs among the accounts subject to the tax. [4]
The debt-related category is called unrelated debt-financed income, or UDFI. Part of the income comes from assets bought with borrowed money. The tax law may treat that part differently from income earned with the account's own funds.
Paying cash for the DST interest does not necessarily avoid this issue. The underlying real estate may have a mortgage. Review the debt tied to the investment, not just whether your IRA borrowed directly to write its subscription check.
A nonrecourse loan does not remove the tax issue. Nonrecourse generally limits what the lender can pursue for repayment. The tax rule asks a different question. A property bought subject to a mortgage can have acquisition debt even if the buyer does not take on personal liability. [4]
Have the offering's tax section reviewed before you subscribe. Ask whether IRA investors are expected to receive UDFI, what records will support the calculation, and when those records should arrive. An estimate is useful for planning, but the return must use the actual year's facts.
A shortcut sometimes says that 50% loan-to-value means half the cash payment is taxable to an IRA. That is too simple. For annual income, the federal rule generally uses average acquisition debt divided by average adjusted tax basis. Tax basis is not current market value. The resulting share applies to gross income and allowed deductions. [4]
Consider a hypothetical share of a property with $400,000 of average acquisition debt and $800,000 of average adjusted basis. The ratio is 50%. If the relevant gross income is $60,000, the debt-financed share of gross income is $30,000.
Assume $24,000 of allowable, directly connected deductions for this simplified example. Applying the same 50% gives $12,000 of deductions against that $30,000. The result is $18,000 before other applicable adjustments, including the specific deduction. It is not an $18,000 tax bill.
The calculation needs tax records, not just a payment history. Distributions may differ from taxable income. Depreciation and debt balances change. Deductions have their own limits, and Publication 598 specifies straight-line depreciation for this calculation. [4]
A sale brings a different calculation. It uses the highest acquisition debt during the 12 months before sale. That debt is compared with average adjusted basis to find the share of gain covered by the rule. Paying off the loan just before a sale does not necessarily avoid the tax. [4]
These examples explain why the CPA needs more than the brochure's LTV and cash-flow rate. Have the tax preparer assess both annual income and the planned exit. Do not use a simple percentage of cash received as your final tax estimate.
If no relevant acquisition debt exists, there is no borrowing to drive that debt-financed income calculation. That can simplify one part of the review. It does not mean every dollar from every all-cash offering is free of UBIT.
Rent from real estate is generally left out of unrelated business taxable income. But exceptions exist. What services does the owner provide to occupants? Is rent based on profits? Does the lease include other assets as well as real estate? Is there debt? Each question can affect the tax result. [4]
Have the CPA review what generates the income and how it reaches the IRA. A property's marketing category is not a tax opinion. Changes to the structure or activities can also require a fresh look.
An all-cash DST still has investment risk. Tenants can leave, expenses can rise, distributions can fall, and a sale can produce a loss. Removing a mortgage does not guarantee income, a return of principal, or an available buyer when you need cash.
IRS instructions generally require an IRA with $1,000 or more of gross unrelated trade or business income to file Form 990-T. That is a gross-income filing threshold. It is not a rule that only cash payments above $1,000 matter, or that a low final tax bill removes the filing duty. [5]
Each IRA is treated separately for this purpose. An IRA filing Form 990-T needs its own employer identification number, or EIN. It does not use your Social Security number or the custodian's EIN on that return. [5]
Ask the custodian exactly what it does. Will it prepare a return, work with your CPA, or only sign and submit a return prepared elsewhere? Who requests an extension? Who handles estimated payments? What are the fees? Do not assume an account service includes tax preparation.
Plan for payment from the IRA and confirm the mechanics with the custodian and tax adviser. Keep enough account cash for potential tax, filing costs, and other charges. Ask about any state filing duties too.
If you own several private investments, provide all their tax information. Special rules govern separate unrelated businesses and the use of losses. A loss on one holding is not a blanket promise that it offsets every other holding's taxable income. [4]
Prohibited transactions are a separate issue from UBIT. The IRS gives examples such as borrowing from your IRA, selling property to it, or using IRA funds to buy property for personal use. Rules also cover dealings involving certain family members and other disqualified persons. [3]
Do not sell your own DST interest to your IRA as a simple way to move it into a retirement account. Do not use an IRA-owned property for personal needs. If you or a family member has a business connection to the sponsor, property, tenant, or transaction, disclose it to qualified counsel before proceeding.
The result can reach beyond one investment. Generally, if an owner or beneficiary takes part in a prohibited transaction, the involved account loses its IRA status. That takes effect as of the first day of that year. The law treats all the account's assets as paid out at their fair market values on that date. Income tax and added taxes may result. [3]
That is different from the account owing tax on a portion of investment income. Do not confuse a manageable UBIT filing with permission to enter a prohibited transaction. When a proposed arrangement mixes your personal finances and IRA assets, resolve the rules first.
You may be able to move funds directly between trustees of compatible traditional IRAs. That transfer is generally tax-free. It is not a rollover subject to the one-per-year IRA rollover limit, because the money is not paid to you. Other account types and Roth conversions can follow different rules. [6]
Work with both custodians on the transfer. Check the name on the account and when the cash will arrive. Review the purchase forms and funding deadline. Do not move retirement money into your own checking account just because it seems faster.
Regular annual IRA contributions generally must be cash. You must qualify to contribute and stay within the limits. You cannot use a building or DST interest you own as that annual contribution. Allowed transfers and rollovers of assets already in retirement plans are a different matter. [6]
A custodian's willingness to hold the DST is not an endorsement. Its job is generally to hold and administer assets. The SEC warns that these custodians do not judge the deal's quality or check its financial claims. You still need to have the offering reviewed. [1]
Read the private placement memorandum, or PPM, and the purchase forms. Review who may invest, the minimum amount, fees, risks, and title requirements. Work with the people helping you. Having enough money to meet a minimum does not mean the DST fits your needs.
A traditional IRA owner may need required minimum distributions, or RMDs. The math generally uses the prior year-end account value and the correct IRS factor. A DST payment into the IRA does not itself meet the RMD. The required amount must leave the IRA. [3]
Suppose your advisers calculate a $20,000 RMD for the year. Your IRA expects $14,000 of DST cash payments and holds $4,000 in cash. Even if every expected payment arrives, those two sources total only $18,000. You still need a plan for the $2,000 gap, plus fees and any taxes paid by the account.
Now test a distribution cut or delay. The IRS withdrawal deadline does not simply move because a property has not sold. Build enough flexibility that a sponsor's target exit is not your only way to meet an account obligation.
Owners of multiple traditional IRAs generally calculate each account's RMD separately, then may take the combined amount from one or more of those IRAs. Do not extend that rule automatically to employer plans, inherited accounts, or Roth accounts. Ask your adviser which accounts can be combined. [3]
An in-kind distribution of a DST interest may be worth discussing, but it requires advance work. Check transfer terms, required approvals, valuation, paperwork, and tax consequences with the sponsor and custodian. It is not a guaranteed last-minute fix or a way to turn the interest into cash.
The original owner of a Roth IRA does not have lifetime RMDs. Beneficiaries can face withdrawal rules after the owner's death. A Roth account's lack of lifetime RMDs also does not remove the investor's own need for cash or the possibility of UBIT. [3] [4]
Private real estate does not have a live stock-market price. Yet its value matters for account reports, RMDs, transfers, and withdrawals. The IRS puts an annual duty on trustees and custodians to ensure IRA assets are valued at fair market value. That includes assets without a ready market. [7]
Ask how the value is developed, what date it reflects, and whether it includes updated property and debt information. A number repeated on several statements is not proof that the investment's economic value stayed unchanged. A reported value also is not a bid from a buyer.
Review the investment costs and the account costs together. The DST may have costs at purchase, during operation, and at sale. The custodian may charge for opening the account, holding private assets, transactions, distributions, valuation work, or tax administration.
Consider a simple example. The account receives $12,000 in annual cash payments from a DST. Account and tax-filing costs total $1,200 that year. Those charges use 10% of the cash received. This is not a full return calculation, but it shows why service charges belong in your cash budget.
Finally, compare the DST with other ways to invest the retirement account. Assess fees, expected holding time, potential losses, income sources, and access to cash. The decision should rest on investment merit and account fit, not on the fact that a custodian is willing to hold it.
Before funding, put the key answers in writing: Who owns the interest? Who handles taxes? Where will cash payments go? How will you meet withdrawals? What happens if the sale is delayed? Keep that record with the final offering documents so your plan is clear after the purchase too.
It may be able to. Both the custodian and the offering must allow it. Check the purchase terms, tax issues, and fit before moving funds. The IRA holds the DST interest. Use the account's required title and funding process.
Yes. Roth IRAs are subject to the unrelated business income tax rules. Debt-financed income can create tax within the account even though qualified withdrawals by the owner are tax-free. Review both the property's financing and the account's expected filing duties. [4]
No. Your IRA can pay the subscription entirely in cash while the underlying property has a mortgage. Ask for the actual debt details. The debt-financed income calculation is not determined solely by how the IRA paid for its interest.
No. An absence of relevant acquisition debt can address UDFI. Other business income rules may still matter. Have a CPA check how the property earns money, how it is owned, and what the tax disclosures say. An all-cash label is not enough. [4]
Do not assume so. Ask which tasks the agreement includes, who obtains the IRA's EIN, who prepares the return, and how payment works. The filing obligation belongs to the account even if several service providers help carry it out. [5]
Cash received by the IRA may fund a withdrawal, but the payment into the IRA does not itself meet the RMD. Confirm the amount to withdraw, its deadline, available cash, and the custodian's processing time. Do not rely on projected payments that might change.
No. Custodial administration is different from reviewing investment quality. Examine the sponsor, property, debt, fees, and risks. Private placements may be difficult to sell and can lose value, including the entire investment. [1] [8]
Work with your investment professional, custodian, and a CPA who knows self-directed IRA tax rules. Bring in an attorney for questions about title, related parties, or prohibited transactions. Each has a different job. Make sure you know who does what and what it costs.
Educational information, not an offer or a personal tax, legal, or investment recommendation. Examples are hypothetical and omit stated adjustments. Tax treatment depends on your facts and current law. Review your transaction with your CPA, attorney, and qualified intermediary. Real estate investments can lose value and may be illiquid.
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