How does Unrelated Business Income Tax (UBIT) work?

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. 

UBIT: What is UBIT and do I need to pay it?

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