Is My Real Estate IRA Investment Considered Debt or Equity?

The IRS distinguishes debt and equity investments in real estate based on several key factors. These factors help the IRS determine whether a Self-Directed IRA investor’s return should be treated as an equity/ownership interest or as a lender (debt).  

Understanding whether an investment is treated as debt or equity is important because it can affect whether the income is taxed and if the investment triggers the Unrelated Business Taxable Income (UBTI) tax, and how ownership rights are recognized. The UBTI tax could have a big impact in a tax-efficient IRA investment. This is why it is important for investors to understand how the IRA would treat the investment. If it is tied to a fixed interest or loan, it would be treated as debt and not subject to the UBTI tax. Whereas if the investment is based on the success and ownership stake in the investment, the investment could be viewed as equity by the IRS and potentially subject to the UBTI tax.

Key Factors Considered by the IRS

The IRS generally uses a facts and circumstances approach to determine whether a Self-Directed IRA investment is classified as debt or equity. The main factors include:

1. Intent of the Parties: What the parties involved intended at the time the investment was made is crucial. If the investor intended the investment to be a loan with fixed repayment terms, it may be classified as debt. However, if he or she is taking on risk and the return is tied to the performance of the real estate (profits or appreciation), it is likely to be considered equity.
2. Presence of a Fixed Return: Debt is often characterized by a fixed return (like interest payments on a loan), while equity investors typically receive variable returns based on the performance of the investment. If the investor’s return is fixed or capped, it suggests the investment is debt.
3. Repayment Obligation: Debt usually has a formal obligation for repayment, with a set maturity date. Equity, on the other hand, represents an ownership stake with no fixed repayment. The IRS will look at whether there is a clear repayment schedule or obligation tied to the investment.
4. Security Interest: A debt investment is often secured by collateral, such as a mortgage or lien on the property, which gives the lender the right to recover assets if the borrower defaults. Equity does not usually have such security and involves greater risk.
5. Subordination: In the event of a liquidation or bankruptcy of the entity holding the investment, debt holders typically have priority over equity holders in receiving payments. If the investment is subordinated to other creditors, this may indicate an equity investment.
6. Voting Rights and Control: Equity investors typically have voting rights or some level of control over the real estate project or business, while debt holders generally do not. If the Self-Directed IRA investor has some level of influence over decisions related to the property or project, the investment is more likely to be treated as equity.

Case Law and IRS Guidance

John Kelley Co. v. Commissioner, 326 U.S. 521 (1946)

This landmark case established that the distinction between debt and equity is based on the substance of the transaction, rather than just the labels used by the parties. The Supreme Court emphasized that courts and the IRS must look at the economic reality of the investment rather than just how the parties describe it in agreements.

Fin Hay Realty Co. v. United States, 398 F.2d 694 (3rd Cir. 1968)

In this case, the Court set out a 16-factor test for distinguishing between debt and equity, which has been widely referenced in IRS rulings. These factors include:

• Fixed maturity date
• Right to enforce payment of principal and interest
• Identity of interest between creditor and shareholder
• The extent to which the interest was subordinated to other creditors
• The intent of the parties and whether the corporation was undercapitalized

This multi-factor analysis is still relevant in helping the IRS and courts determine whether an investment should be treated as debt or equity.

IRS Revenue Ruling 83-98

In Revenue Ruling 83-98, the IRS provided guidance on distinguishing debt from equity in the context of real estate partnerships. The ruling states that for an investment to be classified as debt, it must have a fixed maturity date and a reasonable expectation of repayment. If the investor shares in the profits and losses of the property, the investment is likely to be treated as equity.

IRS Revenue Ruling 85-119

This ruling dealt with debt-equity distinctions in real estate development projects and stated that the intent of the parties, as evidenced by the terms of the agreement, is critical in determining whether the funds provided are debt or equity. The IRS looks at whether the investor’s return is fixed (indicating debt) or tied to project success (indicating equity).

Structuring a Real Estate Investment as Debt Versus Equity

Many Self-Directed IRA real estate investors have structured real estate investments to look like debt versus equity to get around the UBTI tax on the gains. In addition, debt returns are based on interest payments and are less sensitive to market volatility or real estate appreciation/depreciation than equity investments. 

However, the downside of debt versus equity is limited upside. Unlike equity, where you can benefit from property appreciation, debt investors only receive the agreed-upon interest payments. An investor that structures the investment as a debt won’t participate in any gains if the real estate significantly increases in value.

Conclusion

The IRS uses a substance-over-form approach when determining whether a Self-Directed IRA real estate investment is classified as debt or equity. Factors such as the intent of the parties, the nature of returns, repayment terms, security interest, and the level of control all play a role in this determination. The stakes are high as structuring the IRA investment as debt versus equity can help the investor escape the reaches of the UBTI tax.

The John Kelley and Fin Hay Realty cases, as well as various IRS rulings, provide a framework for understanding how the IRS approaches this issue. Investors should strongly consider working with a knowledgeable Self-Directed IRA company that can help carefully structure their real estate investments to maximize tax efficiency and minimize the impact of the UBTI tax.