The Roth 401(k) is here—and so is a way to retire rich using OPM (Other People's Money) without paying taxes, ever! Those of you who read this publication regularly know that I often write about the tax that retirement plans, including IRA's and 401(k)'s, must pay on Unrelated Business Income (UBI) and Unrelated Debt Financed Income (UDFI). This tax is paid by these plans when they own a business in the plan (UBI) or own debt-financed property (UDFI), either directly or indirectly through a non-taxed entity such as an LLC or a partnership. What most people don't know is that 401(k) plans enjoy an exemption from the tax on UDFI for income from debt-financed real property in certain circumstances. Combining this exemption with the powerful new Roth 401(k) is one of the most exciting opportunities to build your retirement wealth since the Roth IRA came along in 1998.
The real estate exception to the tax on UDFI is found in Internal Revenue Code (IRC) §514(c)(9), and applies only to "qualified organizations." Qualified organizations include certain educational organizations and their affiliated support organizations, a qualified pension plan (i.e. a trust qualifying under IRC §401), and a title-holding company under IRC §501(c)(25), but only to the extent it is owned by other qualified organizations. IRA's are trusts created under IRC §408, not IRC §401, so the real estate exception to the UDFI tax does not apply to IRA's. The good news is that plans such as the Entrust Individual (k) Plan do qualify for this exception under the right circumstances.
There are six basic restrictions which must be met for the exemption from the UDFI tax to apply. They are:
1. Fixed Price Restriction. The price for the acquisition or improvement must be a fixed amount determined as of the date of the acquisition or the completion of the improvement.
2. Participating Loan Restriction. The amount of any indebtedness or any other amount payable with respect to such indebtedness, or the time for making any payment of any such amount, must not be dependent, in whole or in part, upon any revenue, income, or profits derived from such real property.
3. Sale and Leaseback Restriction. The real property must not at any time after the acquisition be leased by the qualified organization to the seller of the property or to certain related persons, with certain small leases disregarded.
4. Disqualified Person Restriction. For pension plans, the real property cannot be acquired from or leased to certain disqualified persons described in 4975(e)(2), with certain small leases disregarded.
5. Seller Financing Restriction. Neither the seller nor certain related disqualified persons may provide financing for the acquisition or improvement of the real property unless the financing is on commercially reasonable terms.
6. Partnership Restrictions. Partnerships must meet any one of three tests if the exemption from the tax on UDFI is to apply to the qualified organizations who are partners. First, all of the partners can be qualified organizations, provided none of the partners has any unrelated business income. Second, all allocations of tax items from the partnership to the qualified organizations can be "qualified allocations," which means that each qualified organization must be allocated the same distributive share of each item of income, gain, loss, deduction, credit and basis. These allocations may not vary while the qualified organization is a partner in the partnership, and must meet the requirement of having a "substantial economic effect." Third, and perhaps most commonly, the partnership must meet a complex test called the "Fractions Rule" (or the "Disproportionate Allocation Rule").
Even with the restrictions, there are circumstances where this exemption can work. For example, one client rolled over her IRA into a 401(k) plan she created for her home-based interior decorator business. The 401(k) plan then purchased 2 apartment buildings with non-recourse seller financing (which was on commercially reasonable terms). Not only is the 401(k)'s rental income exempt from the tax on UDFI, but so will the capital gains be exempt. If there is a concern about asset protection, a title holding §501(c)(2) or §501(c)(25) corporation can be formed, and the exemption will still apply.
But the best news of all is that we now have the Roth 401(k). Starting in 2006, if your plan allows it, you can defer up to $15,000 ($20,000 if you are 50 or over) into the plan. Although the salary deferrals are post tax (meaning you still have to pay income, social security and Medicare taxes on the amount deferred into the plan), the gains are tax free forever. Unlike the Roth IRA, there are no maximum income requirements. Combining the power of an Entrust self-directed Roth 401(k) and the real estate exception for 401(k) plans under IRC §514(c)(9) means you can use Other People's Money to purchase real estate and never pay taxes on the income and capital gains.
H. Quincy Long is a Certified IRA Services Professional (CISP) and an attorney. He is also President of Entrust Retirement Services, Inc., with offices in Houston and San Antonio, Texas. He may be reached by email at QLong [at] EntrustTexas [dot] com. Nothing in this article is intended as tax, legal or investment advice.