Securities brokers and some accountants will be the first to
tell you that you don’t want leveraged property in either a Traditional or a
Roth IRA because you will have to pay additional taxes, specifically Unrelated
Business Income Tax (UBIT).
How UBIT Works
UBIT was instituted as a way to level the playing field
between non-profit and for-profit companies doing similar work.
For example: A Homeowners’ Association “Dairy Glen”, a
non-profit corporation, has installed a pool and tennis courts for its residents.
These facilities are supported by the HOA dues, paid by the residents of that
neighborhood. At some point the HOA board decides that they are going to open
the recreation facilities to the public and charge admission or offer
memberships, all funds going back to the HOA accounts.
Down the road is “Muscle World, Inc.” a gym that offers
similar facilities to their members. Muscle World pays taxes like any other
corporation but has a tough time competing with Dairy Glen because they have to
pay taxes. This is where UBIT enters. The government, in order to force fair
competition levies UBIT on Dairy Glen because they are now in a business that
is unrelated to the original business of maintaining neighborhood facilities.
So how does UBIT
relate to IRAs?
The government will give you tax-deferred status on the
income generated by whatever you have in the IRA. However, it is not willing to shelter the profits of
the income generated by funds brought into the account in the form of a loan.
The IRA is treated like a non-profit but the additional
funds brought in are not. This is because the IRS doesn’t allow unlimited
ability to contribute to a tax-advantaged plan. The amount of money you can
shelter within an IRA is limited by the annual contribution limits, so by
taking out a mortgage, you are increasing the size of your IRA.
For example, if your IRA buys a home using a mortgage, UBIT
will be assessed on the leveraged portion, not the portion that your IRA
contributed. Thus as your IRA pays off the mortgage, the percentage that incurs
UBIT will decrease.
UBIT is assessed at corporate tax rates.
Quick UBIT
Facts
-
LLCs will not protect you from UBIT, it still
applies
-
The IRA pays the tax, not you.
-
The IRA has its own tax return and this return does
not affect your personal tax return
-
For most leveraged real estate deals, an IRA
does not pay UBIT until somewhere between years 4 to 8 because of depreciation.
UBIT is
generated by an IRA in three ways:
1. The net income generated by the leveraged portion
of an investment at trust rate.
2.
Proceeds of a sale taxed based on balance of
debt at time of sale at capital gains rate (short term gains are taxed at the
trust rate.)
3.
The IRA owns an operating business such as
providing goods or services. Tax is on 100% of the net income using the trust
rate. (This situation is not covered in this article.)
UBIT
Illustrated
A good exercise is to take the same size IRA and calculate
the gain on a property with zero leverage. Compare this property bought with
varying degrees of leverage. Estimate the income generated by renting the
property, and see what UBIT may be over the next 4 to 8 years.
Before someone talks you out of leveraging a property within
an IRA, do the numbers and decide for yourself. It may or may not make sense to
use a mortgage but at least you will understand the decisions you make when
investing your IRA money.
Remember that a self-directed IRA is the only way you can
purchase real estate AND have a mortgage on it.
