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 your IRA can purchase real estate AND have a mortgage on it.