With a Solo 401k, flipping homes or engaging in a real estate transaction is as simple as writing a check. As a trustee of your Solo 401k Trust you have the authority to make real estate investment decisions on behalf of your Solo 401k Trust. However, when engaging in a transaction such as flipping a house, it is very important to understand the UBIT and UBTI Rules (Unrelated Business Taxable Income Rules).
UBTI and UBIT rules
The purpose of the UBTI or UBIT rules is to treat tax-exempt entities, such as charities, qualified plans (IRAs and 401(k)s) as a for-profit business when they engage in active business activities or use leverage.
The UBTI or UBIT rules generally applies to the taxable income of “any unrelated trade or business…regularly carried on” by an organization subject to the tax. The regulations separately treat three aspects of the quoted words—“trade or business,” “regularly carried on,” and “unrelated.”
- Trade or Business: In defining “unrelated trade or business,” the regulations start with the concept of “trade or business” as used by Internal Revenue Code Section 162, which allows deductions for expenses paid or incurred “in carrying on any trade or business.”
- Regularly Carried On: The UBIT or UBIT rules generally only applies to income of an unrelated trade or business that is “regularly carried on” by an organization. Whether a trade or business is regularly carried on is determined in light of the underlying objective to reach activities competitive with taxable businesses. The requirement thus is met by activities that “manifest a frequency and continuity, and are pursued in a manner generally similar to comparable commercial activities of nonexempt organizations.” The determination of whether an activity is “regularly carried on” is generally a fact and circumstances test and is based on the particular facts of the transaction or set of transactions during the year.
- Unrelated: In the case of an IRA or 401(k) Plan, any business activity will be treated as “unrelated” to its exempt purpose.
In the case of a 401(k) plan, a transaction would not trigger the UBTI or UBIT rules if the transaction is deemed not to be considered a trade or business that is regularly carried on. This typically involves passive types of activities that generate capital gains, interest, rental income, royalties, and dividends. The passive income exemptions to the UBTI or UBIT rules are listed in Internal Revenue Code Section 512. However, if the tax-exempt organization engages in an active trade or business, such as a restaurant, store, or manufacturing business, the IRS will tax the income from the business since the activity is an active trade or business that is regularly carried on.
The question is then asked, what level of real estate transaction must one cross before triggering the UBTI or UBIT tax. Unfortunately, there is no clear test as to how many house flipping transactions or the number of real estate transactions one must engage in a given year in order to trigger the UBTI or UBIT tax. In general, the IRS has a number of factors it will examine to determine whether one has engaged in a high enough volume or real estate transactions, such as home flipping, to trigger the UBTI or UBIT. Firstly, the IRS will examine the frequency of the transactions - how many flipping transactions are done in a year. Secondly, the IRS will examine the intent of the person - was the person intending to engage in an active trade or business. Thirdly, the IRS will also look at the scope of other activities of the tax-exempt entity to determine whether the activity is part of a business activity or an investment.
The determination of whether an activity is an active trade or business and will, thus, trigger the UBTI or UBIT tax, which is taxed at a rate of approximately 40% for 2015, depends on the facts and circumstances. One or two flipping transactions would probably not be considered an active trade or business and would, thus, not trigger the UBTI or UBIT tax. The question then becomes what happens if you do several flipping transactions in a year – would that be considered an active trade or business and, hence, trigger the UBTI tax? Again, one must examine all the facts and circumstances surrounding the multiple house flipping transactions in order to determine whether the transactions in the aggregate would constitute an active trade or business. Therefore, it is important to work with a tax professional who can help one evaluate the transaction to determine whether the flipping transaction will trigger the UBTI or UBIT tax.