Entrust New Direction Blog

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 taxes in the form of "UBIT". The motivations of the anti-UBIT crowd speak for themselves, but, in nearly all decisions related to leveraging an IRA property or not are about doing the numbers. There is some feeling that UBIT is actually wrong, or a penalty for doing something you shouldn't, in fact, it is part of the tax law that usually pertains to non profit organizations and has been around for a long time.

Non Profits and UBIT

This is how UBIT and non profits are related: A Homeowners' Association "Dairy Glen", a non-profit corporation, has installed a pool and tennis courts for the 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. How does this relate to the IRA?

IRAs and UBIT and Leverage in Real Estate

The amount of money you can shelter within an IRA is limited by the annual contribution limits and by how much an employer is allowed to put into your 401k which you may ultimately roll over to an IRA. They really don't want to give you unlimited ability to contribute to a tax-advantaged plan. If you bring additional funds into the IRA in the form of a mortgage, you are increasing the size of your IRA.

The government is willing to give you tax-deferred status on the income generated by whatever you have in the IRA initially but is not willing to shelter the profits of the net income generated by the extra 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. Thus UBIT enters the picture.

Some Quick Facts

• When calculating UBIT from rental income it is only the NET income generated by the debt leveraged portion, after the deduction of operating expenses, interest and depreciation.
• 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 affects neither you nor your tax return
• For most leveraged real estate deals an IRA does not pay UBIT until somewhere between years 4 to 8 because of depreciation.
• Losses carry forward so file from inception

UBIT is generated by an IRA in three ways:

1. Net income generated by leveraged portion of an investment @ trust rate
2. Proceeds of a sale taxed based on balance of debt at time of sale @ capital gains rate (if 1 year or more after purchase, short term gains 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

The best way to look at UBIT is not a snapshot but across several years. As mentioned earlier, most leveraged IRA properties don't generate UBIT until between years 4 and 8. This illustration shows year 1, the second looks at year 8.

Summary of key points on calculating UBIT:

• Taxed on Net Operating Income * Debt Financed %
• Taxed on Capital Gains at sale * Debt Financed %
• Debt Financed portion is recalculated each year.
• Tax is only a percentage of Debt Financed net income.
• Calculation of debt-leveraged % is actually the loan balance/depreciated basis of the property

John's Uncle IRA buys an investment property using a non-recourse loan*:

First Full Year of Operation

• Cost of property: $500,000
• IRA investment: $200,000
• Non-recourse Loan: $300,000
• Leverage: 60%
• Mortgage Pmt: $1,600/month
• Taxes & Insurance: $400/month

Other information:

• Rent: $2,500 per month
• Utilities: paid by tenant
• Net Cash Flow: $490/mo = $5,874/yr
• Depreciation: $14,545/yr.
• Principal Payments $4,474
• Interest Expense: $14,720 (4.95%)
• Net Loss Year One ($4,265)
• Annual Appreciation 2.5%

No UBIT is paid.

Year 8

• Rent: $2,951 per month T&I $475
• Utilities: paid by tenant
• Net Cash Flow: $876/mo = $10,512/yr
• Depreciation: $14,545/yr.
• Principal Payments $6,318
• Interest Expense: $12,876
• Net Income Year Eight $2,296

Calculation of UBIT:

Debt Balance/Depreciated Basis:

• 263,835/398,182 = 66.26%
• Net Income * 66.26% = $1,521
• UBI = $1,521- $1,000 = $521
• Tax ~ $104

Year 8

• Sale Price $609,201
• Costs of sale 3% - $18,276
• Net Proceeds = $590,925
• Current year Debt Financed % - 66.26%
• Capital Gain ($590,925-$426,587)=$ 164,338
• (Note $426,587 = depreciated basis)
• UBI portion $108,757

UBIT: $23,655
Gain: $164,338 - 23,655 = $140,683

A good exercise is to take the same size IRA and calculate the gain on a property with zero leverage. It would be difficult to determine the income generated by rental operations but, at the end of year 8, with the same appreciation would be $36,370 after deducting the cost of selling of 3%.

Before someone talks you out of leveraging a property within an IRA, do the numbers and decide for yourself. It may or may not made sense to use a mortgage but at least YOU will understand the decisions you make when investing your IRA money. A self-directed IRA is the only way you can purchase real estate AND have a mortgage on it. The flexibility of the self-directed IRA can provide you a world of choices regardless of which way the numbers go.

Catherine Wynne is a Principal in Entrust New Direction IRA, Inc. a self-directed IRA administrator. She is also a Principal in IRA Tax Services, Inc. A tax service company devoted entirely to IRA tax filings for Unrelated Business Income Tax ( UBIT or UBTI).