Entrust New Direction Blog

When the first King levied the first tax on the first farmer, humanity began our hate/hate relationship with taxes and, in some cases, tax collectors.  I can imagine that the biggest and meanest person would be tax collector, and this object of dread would take just about everything the farmer didn't already use.  Thankfully, these days, we are able to work a little magic with IRAs, HSAs and other tax-deferred and tax-free options. 

Of course it's not magic, but it sure can seem that way unless you're a CPA in title or experience level.  We here at Entrust New Direction have had so many questions about UBIT, taxes on IRAs and taxes on other retirement accounts,  we decided to open an accounting firm, IRA Tax Services, Inc. - specifically to help people with these types of accounts.

However, as education is really our #1 priority, we want to share some answers with you in a couple different FAQ blog posts.

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. You referred to net income. 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 (Unrelated Business Taxable 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 A Wall Street Journal Article that I found says ". . . 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."

The quote above states "IRA investors can get around the tax by applying excess profit to the loan principal." Is it true that applying the excess profit from rents to principal pay down will avoid UBIT? Thank you.

Answer: What the article should say is not "get 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 than the cash, and that is not generating income as it has been distributed. It does not enter into the UBIT calculation.

Confused?  Have more questions?  You can always use IRA Tax Services and ask your own question. Or, like some of our clients, just drop off a truckload of documents duct-taped together in a big ball and hope for the best.

Just Kidding.   Please keep your documents organized.

You can imagine the dismay of our fantastically patient Director of Accounting, Deborah Broaddus, when she was in the middle of being flooded with a zillion questions from clients about recently received statements and gets yet another question from me, an employee who should know better, about IRS reporting forms. Well, one of the things I've always loved about my job is that I learn something new every day and evidently this day was the day I would learn about how 1099-R and 5498 forms and IRS reporting work together.

I promised Deborah in exchange for her infinite patience with me that I would share what I learned with all of you, since many may have the same questions that I did. Or something similar.

Have you recently asked yourself, 'Why did I get this 1099-R? I didn't make a distribution.' See below for a list of reasons why people receive 1099-Rs. Depending on the reason you receive a 1099-R, you may or may not have tax consequences (see the discussion of the 5498 form below), but it is still good to understand the form and why you received it.

You will receive a 1099-R if you:
* took a distribution from a retirement account.
* made a conversion of a Traditional IRA to a Roth IRA.
* devalued an asset to zero.
* rolled funds over from a 401k to an IRA or other retirement plan.
* rolled funds over from an IRA to an HSA.

If you did one of the first two items on the above list, your reported income will increase by the amount on the 1099-R form. If your asset was devalued to zero, you essentially are paying tax on a distribution that has zero value. No matter what your tax rate, tax on something worth nothing is also equal to nothing.

If you received the 1099-R form for one of the last 2 reasons listed above, another reporting form becomes relevant, form 5498 which is also filed with the IRS by Entrust New Direction as part of our annual IRS reporting. The 5498 will reflect the results of any rollovers you made to accounts held by us.

For example,if you rolled funds from an IRA to an HSA like my family did, the 5498 will reflect that the amount reported on the 1099-R was rolled over into an HSA and not received by you personally (remember the IRS only allows that once in your lifetime). The same is true if you rolled funds over to an IRA from a 401k plan. The net result is that the 5498 will indicate that the amount reported on the 1099-R did not result in increased income for the current tax year.

Your first statement of the year serves as your substitute form 5498.  You can reference this form for your records. As long as the amounts on the 1099-R match the amount listed as the rollover which funded your account on your statement from us, the net resulting tax is zero. Keep your statement (substitute 5498) and the 1099-R form with your tax files for documentation.