Utilizing debt financing within a tax-defered account like an IRA, may generate unrelated business income tax (UBIT). For investors willing to explore this option the rewards can be substantial. Hesitant about what it takes to stay within the IRS guidelines, some investors let fear of the unknown prevent them from taking advantage of great opportunities, such as paying UBIT. Others are already invested in real estate that incurs UBIT, but may not be aware of the nuances of the tax code, and how it relates to their investment. Yet, if you are willing to learn about the tax, you will soon realize there are many advantages to investments that require the tax and the filings necessary for these investment options.
UBIT versus UDFI
When UBIT is incurred through a real estate investment that leveraged debt financing, the income is taxed based on the amount of UDFI (unrelated debt financed income).
A real estate purchase within an IRA, or other tax-exempt account, that utilizes debt financing is likely to generate UDFI. For reasons that a portion of the purchase that was debt financed came from money provided by the lender, rather than the IRA. Thus income in direct proportion to the debt-financed percentage is derived from money that is not tax-exempt and will likely be subject to UBIT. Investments of this nature may require annual filings (Form 990-T) with the Internal Revenue Service to distinguish the portion of the property that is owned by the IRA, and the portion that is debt financed.
Essentially, the debt financed portion is treated like a separate, non-tax-exempt investor. This means the loan portion of the property value has income and expenses that need to be accounted for in order to determine if any tax is owed on the debt financed portion.
For example, if a property were purchased for $100,000 with a $50,000 non-recourse loan, then the income and expenses would be divided in half. The IRA would receive half the income, minus expenses and is sheltered with tax-free or tax-deferred growth inside the Roth or Traditional IRA respectively. The debt financed portion (50%) would receive half the income minus expenses. Factoring for depreciation, these expenses can be high, leaving only a small portion of income that is actually taxable.
As the loan is paid down, the debt financed portion is reduced, and the percentage that the IRA owns goes up accordingly. If the UDFI is $1,000 or more in a given year, filings must be made in order to remain compliant with the IRS.
Is UBIT Worth the Trouble?
Given that additional forms may have to be filed with the IRS each year, a common question among investors is if the preparation and filing requirements are worth the trouble.
If an investor is able to expand their portfolio by 50% or more, in exchange for filing a few forms, and paying a tax on the extra profits made, then the answer is yes. The trade-off is the potential to double your profits for the cost of filing, and paying UBIT.
The best news of all is that UBIT Professional can prepare Form 990-T for you, and help you determine the tax that may be owed. This relieves the investor of having to deal with the “trouble” of investing in real estate using debt financing, and allows them to focus on the investment returns.