Manage UBIT with a 1031 Exchange

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If your self-directed IRA has ever received income from leveraged real estate, your CPA or tax professional may have mentioned some additional taxes that caught you off guard. Despite incorporating property for the express purpose of avoiding taxes, profits yielded from debt leverage may be subject to unrelated business income tax (UBIT). Like most tax-paying Americans, you may have asked yourself, “What can I do to avoid these taxes?”

Per Internal Revenue Code Section 1031, real estate investors may defer capital gains taxes on profits earned from selling a property if the sale proceeds are used to purchase a like-kind real estate investment. These transactions are called 1031 exchanges. Like alternative asset investing in general, most people don’t realize that self-directed retirement accounts can initiate 1031 exchanges in the same manner as personal real estate investors. If executed properly, your IRA or 401(k) could defer or eventually phase out UBIT obligations using this method.

Let’s review an example to highlight how this works. For simplicity, potential income from these properties will be excluded from our hypothetical calculations and depreciation amounts will be rounded up:

  • Your IRA purchases Property A for $100,000. The plan pays $50,000 and finances the remaining $50,000 (50% debt ratio).
  • One year later, Property A has depreciated to $95,000 but you’re able to sell it for $150,000 through a qualified 1031 company. The $5,000 depreciation may be listed as a tax deduction and is therefore regarded as profit in this context. As such, the sale of Property A has produced a $55,000 profit for your self-directed IRA account. A portion of this profit would normally be taxed in accordance with the debt ratio of Property A.
    • $50,000 (Property A debt)/ $95,000 (depreciated value) = 52.6% (adjusted debt ratio)
    • $55,000 (profit) x 52.6% (adjusted debt ratio) = $28,930 (taxable amount). Taxes would be due per the current trust rate. For the sake of this example, let’s assume your IRA would owe $5,000 in UBIT.
    • Under normal circumstances, your IRA would have to pay the $5,000. By implementing a 1031 exchange, your IRA may retain those funds and apply them toward a replacement property.
  • On behalf of your plan, you elect to acquire Property B for $200,000. Let’s assume your IRA has $75,000 available from investments unrelated to this exchange. If you combine the $75,000 cash balance with the $100,000 from your previous investment (the $150,000 sale of Property A, less $50,000 to pay off the previous non-recourse loan), your IRA will have $175,000 to allocate toward Property B.
  • The $200,000 purchase of Property B will require a new loan of $25,000. In determining the adjusted debt ratio, the basis of Property B will be calculated in accordance with profit earned from Property A.
    • $200,000 (purchase price) - $55,000 (profit from Property A) = $145,000 (adjusted basis for Property B)
    • $25,000 (Property B debt)/ $145,000 (adjusted basis for Property B) = 17.2% (adjusted debt ratio)

As you can see, applying the $75,000 significantly reduced the debt ratio of Property B. However, you may not always have the luxury of extra IRA money to kick into a real estate deal. Your success in utilizing 1031 exchanges will generally reflect the success of the subsequent investments. Ideally, as a more expensive property, Property B would offer greater earning potential than Property A. This would allow your plan to pay off debt more quickly, potentially eliminate it altogether, and sell the property 12 months later or continue receiving rent payments without any further UBIT concerns. Even if your plan doesn’t achieve full equity, you may still defer UBIT payments until a time you deem more advantageous.

It’s highly recommended that you contact a tax professional to discuss qualified like-kind exchanges under Section 1031 and proper tax filing thereafter. New Direction IRA offers a library of educational materials for general information about self-directed investing. You may also contact our office with any questions or concerns.

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