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Purchase house in 401(k)


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The Prohibited Transaction (Pt) rules are the first set of rules that need to be looked at. If this is a PT in any way that will blow this up. I THINK there could be a way to set this up so it isn't a PT but this isn't my area of expertise so I could be wrong. 

Assuming this isn't a PT if they run a for profit business in a plan or use debt to purchase the property the 401(k) plan has to pay taxes on the profits.  Oops I am betting they thought this was a clever way to avoid income taxes on their business didn't they?????  Look up Unrelated Business Income Tax (UBIT) on a plan.  I forget the name of debt financed but like the UBIT if they use debt they have to pay a type of income taxes on the income. Here is the thing.  They have to pay UBIT on the profits and the after tax profits are ordinary income when they take a distribution.  If they run this through a regular S Corp the income flows through to their 1040 and they pay taxes only once on the income.  Even a C Corp if they pay the after tax income as a dividend that is at a lower rate than a 4k plan distribution.  In short there is a good chance this is going to cost more in taxes than outside the 4k plan. 

My guess UBIT is the silver bullet you are looking for. 

If there are participants in the plan is this investment prudent in terms of fiduciary duties?

What happens if the deal loses money and they have to put more money into the plan to cover the loss?   What if that exceeds the various limits? 

If they have most of the money in the property and need to pay a RMD where does the cash come from?

If one takes time you can think of other practical issues that make this a bad idea. 

But strictly speaking it might not be illegal just really stupid. 

 

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Besides being stupid, which it is, and some of the things listed above, they are converting potential capital gain money (if they are NOT deemed to be in the real estate business) into ordinary income.  PLUS, they will need to get an independent valuation of the property each year that would stand up to IRS scrutiny (the real estate broker estimate won't do; they need a proper appraisal - figure upwards of $8 - 10k just for that).  

It's unlikely that this will produce UBTI as they will not be in the business of real estate with just one home.  But they will have the problem of debt financed property unless they pay cash for the house, which does mean a regular income tax return will have to be filed by the plan (expect another couple of thou in costs).

If one of our clients insisted on this, we would walk away from the plan; but that's just us.

 

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The fact of the matter is you cannot tell them that it cannot be done.  All you can do is to give them a list of reasons why it's most likely a bad idea.  You've heard a few of them here.  There are more, which you can find in about 2 minutes through some googling.  On the other hand, maybe you don't want to spend a time  on this if you are not going to get paid for it, which I would understand. 

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9 minutes ago, Larry Starr said:

It's unlikely that this will produce UBTI as they will not be in the business of real estate with just one home. 

 

I am not an expert but I thought any income subject to UBIT over $1,000 meant there was a tax due.  Or are you saying that isn't a business with just one house? 

 

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20 hours ago, ESOP Guy said:

I am not an expert but I thought any income subject to UBIT over $1,000 meant there was a tax due.  Or are you saying that isn't a business with just one house? 

I said that inarticulately! There is no UBTI due to the business aspect because it is unlikely that they will be considered in the real estate business (like a real estate agency would be); there is UBTI due to debt financed property if the real estate is encumbered.  In either case, there is UBTI.  I was just trying to make it clear that it is unlikely that the ownership of the real estate is the problem.  If they bought the real estate with cash and had no debt, it is unlikely it would produce UBTI. UBTI produces UBIT (just to confuse everyone).

Maybe this helps:

However, when debt is incurred by an exempt organization to acquire an income-producing asset, with some exceptions, UBIT is applicable to that portion of the income or gain that is debt-financed. … 

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3 minutes ago, Larry Starr said:

I said that inarticulately! There is no UBTI due to the business aspect because it is unlikely that they will be considered in the real estate business (like a real estate agency would be); there is UBTI due to debt financed property if the real estate is encumbered.  In either case, there is UBTI.  I was just trying to make it clear that it is unlikely that the ownership of the real estate is the problem.  If they bought the real estate with cash and had no debt, it is unlikely it would produce UBTI. UBTI produces UBIT (just to confuse everyone).

Maybe this helps:

However, when debt is incurred by an exempt organization to acquire an income-producing asset, with some exceptions, UBIT is applicable to that portion of the income or gain that is debt-financed. ... 

 

Just exploring it here a little more if you don't mind.

I agree merely holding real estate isn't a business but an investment.  But the original question says they are going to flip the house.  That means to me they are going to buy, pay to have upgrades/repairs done with the intent to sell for a profit.   That sounds like a business to me.   If I did that to one house as a year just as a person it ought to show up on a Sch C not on the Sch D.  That is because I am taken an active role that is outside what you do for an investment. 

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On 11/1/2018 at 6:23 PM, ESOP Guy said:

Just exploring it here a little more if you don't mind.

I agree merely holding real estate isn't a business but an investment.  But the original question says they are going to flip the house.  That means to me they are going to buy, pay to have upgrades/repairs done with the intent to sell for a profit.   That sounds like a business to me.   If I did that to one house as a year just as a person it ought to show up on a Sch C not on the Sch D.  That is because I am taken an active role that is outside what you do for an investment. 

In this case, he almost definitely is an investor and not a dealer.  It is a complicated issue subject to much litigation.  The following longish article discusses the issue quite well and I think you will see why this transaction is not going to make him a dealer in real estate.  Larry.

The dilemma of dealer or investor classification for real estate holdings

INSIGHT ARTICLE  |  October 13, 2014

Title owners of real property need to be aware that various actions taken with regards to real property may affect whether a gain or loss on the sale of the property is capital or ordinary in nature. The actions (or inactions) taken throughout the life cycle of a real property investment determine whether or not specific real estate is held for investment or held as dealer property. Real estate deemed held for investment is subject to favorable capital gain tax rates, while real estate treated as dealer property is subject to less-favorable ordinary income tax rates. In addition to facing higher tax rates on dispositions of property, dealers in real property are precluded from using tax-deferral strategies such as installment sale treatment under section 453 and like-kind exchange treatment under section 1031. 

The issue of dealer versus investor classification has been frequently litigated. Because the federal tax code and regulations do not provide clear guidelines, taxpayers and their advisors must wade through numerous judicial interpretations involving a wide range of differing facts and circumstances in order to make a determination as to the appropriate classification. In general, the case law looks to five main factors in determining the proper classification of a taxpayer as either a dealer or an investor. 

As explained more fully below, a recent Tax Court case, Cordell D. Pool v. Commissioner of Internal Revenue, T.C. Memo 2014-3 (2014),provides a refresher course on the five main factors. It also serves as a reminder that taxpayers and their advisors need to analyze all of the specific facts and circumstances, document the known facts and the representations relied upon, and ensure all tax return filings reflect the appropriate status. The taxpayer bears the burden of proof in any dispute with the IRS. 

The five factors as explained in the Pool decision are briefly discussed below.

Frequency and continuity of sales

Frequent and continual sales of various parcels of real property may indicate that such sales are undertaken in the ordinary course of business, while infrequent sales, often for significant profits, are more indicative of real property held as an investment. In Biedenharn Realty Co. v. United States, 526 F.2d 409 (5th Cir. 1976), the frequency and substantiality of sales were analyzed as the two most important criteria in determining dealer status.

In Suburban Realty Co v. United States, 615 F.2d 171 (5th Cir. 1980), a corporation held large volumes of land it had received from its shareholders. The corporation then sold more than 240 separate parcels to different buyers over a period of 33 years. The corporation engaged in no solicitation, advertising, development activity or subdivision activity and did not act as a broker. Despite other facts that would typically suggest capital gain treatment, the court found that the continuous sales activity by the corporation over 33 years and the large number of discrete sales (240 over a 33-year period) were overriding factors compelling the conclusion that the corporation was selling its land parcels as a dealer in the ordinary course of business.

By contrast, the Tax Court in Buono v. Commissioner, 74 T.C. 187 1980, concluded that the taxpayer was entitled to capital gain treatment upon a single sale of land, despite the fact that the taxpayer was involved in activities related to zoning and subdivision. Buono acquired undeveloped land with the intention of subdividing the property into smaller lots to increase the property's value and promptly selling the property once it secured municipal approval of the subdivision. In Buono, the court reasoned that although the taxpayer was involved in subdividing and zoning activities, the land was disposed of in a single asset sale and should accordingly be treated as investment property eligible for capital gain treatment. The court reasoned that the taxpayer did not engage in frequent sales, did not make any improvements to the land, and engaged in the subdivision merely to make the land more marketable for sale by the party to whom it sold the subdivided tract. It should be noted that Buono was able to prove its intention from the beginning was to sell the land to a single buyer.  
 

Nature and extent of improvements and development activities

If a taxpayer's activities with regards to a tract of land include subdividing, grading, zoning, or installing roads and utilities, the taxpayer may be deemed a dealer due to the nature of the development activity performed. It should be noted that this factor should be studied in relation to the particular parcel or tract of land involved. The mere fact that the owner of an investment parcel is also engaged in development activities with respect to other parcels should not be relevant to the tax treatment of a parcel genuinely held for investment.

The courts closely study the specific facts and circumstances in a case where there is some level of improvement and development to real property in relation to the other four factors. Some cases in this area have allowed capital gain treatment despite a high level of development activity, and in other cases, mere zoning activities have tainted the property to be dealer property. 

In Pritchett v. Commissioner, 63 T.C. 149 (1974), the taxpayer was in the business of developing real estate and acquired a particular parcel of property that he intended to hold for investment. On prior year returns, the taxpayer recognized ordinary income on the sale of real estate that he held for development (parcels he subdivided and developed). In this case, the IRS argued the gain on the sale of the parcels that Pritchett claimed were held for investment should also be recognized as ordinary income, similar to the treatment of the parcels he sold in the past. The court found in favor of Pritchett and allowed capital gain treatment on the property because Pritchett made no effort to subdivide or improve the property and the property was sold after he received an unsolicited offer from a third party.  
 

Solicitation, advertising and sales activities

Another important factor to explore in the determination of investor versus dealer status is the extent of the taxpayer's sales and marketing effort related to the disposition of a particular parcel of real estate. If the taxpayer advertises, markets, solicits customers, or merely lists the property for sale, it is more likely that there will be ordinary treatment on an ultimate sale.

In Biedenharn Realty Co. v. United States, 526 F.2d 409 (5th Cir. 1976), cert. denied, 429 U.S. 819, the court denied capital gain treatment to a taxpayer that acquired land  with the original intent to hold for investment. Although there were some other negative factors (some development and frequent sales), the court spent considerable time focusing on the taxpayer's solicitation and advertising efforts. The court noted the amount of signage used for marketing purposes as an important factor in concluding that the taxpayer was a dealer, not an investor. Furthermore, the court noted that the use of an independent broker to solicit sales does not shield a taxpayer from being treated as a dealer. This case is similar to others where a taxpayer may have some factors suggesting ordinary income, but the extent of the taxpayer's sales and marketing activities is the nail that seals the coffin, requiring dealer treatment. 
 

Extent and substantiality of transactions

The overall level of the taxpayer's real estate activities, with a particular focus on the extent to which the taxpayer's main occupation is developing property for sales to customers in its ordinary line of business, also factors into the dealer versus investor determination. Questions the courts have examined include whether the taxpayer owns or operates a related construction, development or brokerage business; whether the taxpayer has performed similar activities on other parcels of real property; how many parcels and sales the taxpayer has been involved with in the past; whether the taxpayer has a full-time occupation other than real estate; and whether the taxpayer has a history of syndicating buy-and-hold real estate investment vehicles for investors.
 

Nature and purpose for holding property

Finally, courts have extensively analyzed the taxpayer's intent in acquiring and holding the property. The ultimate questions are “why did the taxpayer buy the real property in the first place?” and “for what purpose was the property held at the time of sale?” 

In Moore v. Commissioner, 30 T.C. 1306 (1958), taxpayers acquired property by gift and liquidated the tract of land by selling 22 lots over an 11-year period. The court in Moore found in favor of the taxpayer and allowed capital gain treatment. The Tax Court noted that one may liquidate an asset in the most advantageous way and still obtain capital gain treatment. The real question is whether, at the time of sale, the property is held merely for liquidation or whether the owner has entered into the business of holding property primarily for sale to customers in the ordinary course of the business.  In Moore, the taxpayer's method of disposal was chosen merely to maximize proceeds. The court found that the intent was never anything other than to receive the maximum proceeds on sale–intent consistent with investor treatment. Further supportive facts were that the taxpayer did not engage in extensive development or sales activities during the 11 years of sales.

Courts have also found that a taxpayer's intent may change.  Then, the relevant question is the purpose for which the property was held at the time of its sale. In Nevin v. Commissioner, T.C. Memo 1965-53 (1965), parcels of real estate that were not yet platted were deemed investment property at the time of sale. However, income from sales of parcels that were platted with streets installed before the sale was deemed ordinary. The court in Nevin noted that “when a rapid turnover occurs under the circumstances … and the taxpayer is in the real estate business and originally acquired the property for resale, it stretches the imagination to conclude that the land was held for investment at the time of sale.” The taxpayer in Nevin treated everything as held for investment, but the court deemed that some plots were held for investment and some were held as dealer property.

It is possible for a taxpayer to acquire a large tract of real property, break it into sections, and upon the sale bifurcate the treatment so as to receive capital gain for some plots and ordinary income for others. In Westchester Development, Inc. v. Commissioner, 63 T.C. 198 (1974), the sales of tracts that were subdivided by the taxpayer to sell as sites for construction of single-family homes were sales within the ordinary course of taxpayer's business. However, sales of tracts that had not been subdivided or marketed resulted in capital gain. In such a case, it is generally advisable to separate the plots into separate entities to ensure that one parcel's status does not taint the status of another parcel. It is also important to ensure partnership agreements, investor letters, tax returns and other documents properly reflect language that corresponds to the taxpayer's intent in holding the property.

Planning considerations

The dealer versus investor analysis became even more complex in 2013 with enactment of the net investment income tax under section 1411. Although it is beyond the scope of this article, practitioners should consider the interplay between a dealer or investor classification and the treatment of the property under section 1411.

It is important to be proactive in the consideration of the various factors that the courts have referenced in determining dealer versus investor status. Decisions and actions that occur early in the acquisition phase of real estate investments can have far-reaching implications for the taxability of real estate investments. Taxpayers should consult with their tax advisors to determine the most appropriate classification status–dealer or investor.

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  • 1 month later...

An issue to add to the list is liability protection. House causes losses to third parties, e.g. a fire starts there, spreads to other houses, someone enters premises and is injured, etc. Very unlikely, but possible. There is nothing in state tort law that would limit damages to the single participant's account. In theory, plaintiffs could come after the entire plan, since the plan trust is the owner of property. At a minimum, make sure participant puts the property in an LLC, has adequate insurance, and signs an indemnification agreement with plan trustee.

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On 11/1/2018 at 6:23 PM, ESOP Guy said:

Just exploring it here a little more if you don't mind.

I agree merely holding real estate isn't a business but an investment.  But the original question says they are going to flip the house.  That means to me they are going to buy, pay to have upgrades/repairs done with the intent to sell for a profit.   That sounds like a business to me.   If I did that to one house as a year just as a person it ought to show up on a Sch C not on the Sch D.  That is because I am taken an active role that is outside what you do for an investment. 

You don't ask a question but make a statement.  Your statement is not necessarily true. And this is quite complicated and is a facts and circumstances situation.  The following (long piece) might be helpful; but this sentence (just below the bullets) is probably the most significant:

The courts have considered the frequency and substantiality of sales as the most important factor.

Buying one house to flip is most likely not going to be considered being in the business of real estate.

Larry.

========================================================

Is it Capital Gain or Ordinary Income?

By Melinda A. Kloster, CPA

One of the questions we often get from real estate developers and professionals is how to preserve the “investment nature” of a property to obtain the favorable tax treatment of capital gains. Obtaining capital gain treatment has the potential to save non-corporate taxpayers up to 20% in taxes when the property is sold since long-term capital gains are generally taxed at a 15% rate compared to ordinary income tax rates that can reach 35%. With proper planning, there are opportunities that taxpayers can take to be able to utilize the favorable tax treatment of capital gains.

Gain or loss from the sale of property that is held primarily for sale is generally treated as ordinary income or loss. Gain from the sale of property that is primarily held as an “investment” is generally treated as capital gain. The purpose of this is to differentiate amongst gain from everyday business operations and gain from assets that have appreciated over a substantial period of time. The courts have ruled that property is held primarily for sale when that is the principal purpose. Taxpayers that hold property for sale are classified as dealers. Distinguishing whether or not you are a dealer versus investor is not always so black and white. There is no tax law that defines the “dealer” status but, rather, it is based on facts and circumstances. As a result of there being so much judgment involved, this is an area that the IRS frequently audits.

Therefore, keeping in mind substance over form, the more factors that you have in favor of “investment” status, the better case you have to obtain capital gain treatment. The careful planning at the beginning of the transaction can often help build your case for this treatment.

You must consider all of the facts and circumstances to determine if the property should be treated as a capital asset. The courts have offered some guidelines in determining whether or not the property is held for sale or if it is a capital asset.

The important facts the tax court often considers when determining if you are a dealer or investor are as follows:

  • The nature and purpose of the acquisition of the property and the duration of the ownership.
  • The extent and nature of the taxpayer’s efforts to sell the property.
  • The number, extent, continuity, and substantiality of the sales.
  • The extent of improvements, subdividing, developing, and advertising to increase sales.
  • The use of a business office for the sale of the property.
  • The character and degree of supervision or control exercised by the taxpayer over any representative selling the property.
  • The time and effort the taxpayer habitually devoted to the sales.

The courts have considered the frequency and substantiality of sales as the most important factor.

There are some simple steps that can be taken to help further support the taxpayer’s case that the property is investment in nature such as:

  • The partnership agreement should state that the entity was formed for the purpose of investing in real estate, and other contracts should state that the property is being acquired to hold for investment purposes.
  • The partnership name should not include words like “developer” or “development” but, rather, words that support the investment nature.
  • The tax return should show the particular assets on the balance sheet as investments rather than as inventory or work in process.
  • The taxpayer should make sure they are doing business in the investment entity’s name rather than through another entity that may have been formed and/or operated for non-investment purposes.

It is important to note that the focus has been less on looking at the taxpayer itself and more on the taxpayer’s initial intent of holding the property for investment purposes.

When planning, keep in mind that, in some circumstances, classifying the property as an investment property is not always the most tax advantageous. If there ultimately is a loss upon sale, then generally being treated as a dealer and having an ordinary loss is more advantageous than being an investor and having a capital loss. Of course, in cases where you are trying to support the dealer status, you need to analyze the same facts and circumstances to make the determination.

In conclusion, when planning these transactions, it is very important that all facets are reviewed. Careful planning from the beginning of these transactions can result in the taxpayer receiving the best tax treatment possible.

 

 
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