As a self-directed IRA provider, we get dozens of questions
about UBIT, taxes on IRAs and taxes on other retirement accounts every day.
Most perplexing to clients, it seems, is Unrelated Business Income Tax, or
UBIT. Here are two of our most commonly asked questions and our answers.
Question: My Roth IRA purchased a rental property,
funding it with 10% from the IRA and 90% from a bank loan. The net income is
$3,000 a year. Is all the net income from this property tax-free? Or is $2,700
taxable and only $300 is tax-free?
Answer: The bank loan part is subject to UBIT. If your calculated
net income is $3,000, after all expenses (including depreciation), then roughly
90%, or $2,700 is taxable to the IRA. The IRA’s first $1,000 would be tax-free,
thus, it would pay tax on $1,700 (around $255). If you didn’t calculate net
income with all allowable expenses and depreciation, then go back and do so. We
often find that IRAs, like other real estate investors, find that they have
positive cash flow but a tax loss. It is important to file the 990-T to report
the loss and thus carry it forward to future years. Also note the debt-financed
percentage is recalculated each year.
Question: An
article I read claimed that any leveraged property in an IRA can trigger
the Unrelated Business Income Tax. When mortgaged investments post a profit of
over $1,000 in any year, the gain beyond $1,000 is taxed at anywhere from 15%
to 40%. IRA investors can get around the tax by applying excess profit to the
loan principal. Once the loan is paid, the UBIT no longer applies to any
profit, and if the property is held for an additional 12 months in the IRA,
eventual sale profits won’t be subject to the tax either.
Is it true that applying the excess profit from rents to
principal pay down will avoid UBIT?
Answer: The article shouldn’t recommend “getting
around that tax”, but instead that paying down the debt balance will reduce the
taxable portion of the income. The intent of the article is to highlight that
by paying off the loan as soon as possible (and then have a 0 loan balance for
a 12 month period), the IRA can reduce to 0 the debt-financed percentage and
thus have no UBIT. The profits from the investment, plus any other available
cash can be used to pay down the loan. Note that this strategy limits your
IRA’s other investment options since the money is going to the bank instead of
buying new investments. Run the numbers to see what makes the most sense in
your situation.
Question Let’s just say my self-directed
IRA purchases a 5% interest in an LLC that buys a shopping
center for cash. In the first year, the LLC has net income of $100,000 and
distributes $5,000 to the IRA. The following year, the LLC obtains a
non-recourse loan of $1,000,000. The LLC uses $100,000 of the loan proceeds to
hire an unrelated
contractor to make improvements to the property, and distributes $900,000 of
the proceeds. $45,000 of this $900,000 is distributed to the LLC. After the
debt is added, net income remains the same, and thus $5,000 of net income is
distributed to the IRA in year two. Is there now unrelated business income, and
if so, how much?
Answer The amount of UBIT is determined on the
percentage of the amount of total indebtedness from the acquisition of the
property. Depending on the business activity of the LLC, it may be that the LLC
is operating a business, and thus all of its earnings may be subject to UBIT as
a result.
Assuming in your example that the LLC is just a passive
rental operation, then you need to calculate the debt financed portion of the
property. Using the property for security for a loan does not make the property
debt-financed unless the money is used on the property. In your case, $100,000
of the loan which was used to improve the property is debt-financed, and income
generated by the overall debt-financed portion is subject to tax (avg
debt/average depreciated basis of the property plus improvements). The other
$900,000 was not used to acquire any asset, other
