So why does it make a difference if your self-directed retirement holding is an investment versus a trade or business?
The answer lies in the IRS codes that were inherited from the non-profit world. As we all know, tax laws have a good bit of behavioral influence in them. Lawmakers (or their for-profit lobbyists) do not want not-for-profit entities competing with them.
If a self-directed retirement fund, IRA or solo 401k is operating a trade or business, there will be tax consequences. Tax is levied at trust rates on any net income over $1,000 and is reported on tax Form 990T (T is for taxable). This is unrelated business income tax (UBIT)
Now you ask, how do we tell an investment from a trade or business?
It is usually determined by a subjective evaluation of the word – intent. It is the intent of the investor to buy and hold. The investor produces income from the investment but also enjoys capital appreciation.
A trade or business produces inventory available for sale to the public. In the real estate world, for instance, it may be the intent of a dealer to buy, fix and flip. A dealer subdivides, converts to condo, remodels or rehabs and sells inventory. A dealer also may advertise inventory for sale.
But what if you invest in a trade or business, as in partnering in ownership?
Your partnership in the ownership of a trade or business is an investment – unless you have controlling interest.
Self-directed retirement plans are meant for investment.
In my opinion, some folks in the advisor business are not paying attention to this distinction. I think it is ripe for examination and the penalties can be staggering. It would be devastating to learn that earnings on the real estate flip business in your self-directed retirement may be taxable. It is worth being cautious and checking in with a trusted advisor.