Investors, financial professionals, and CPAs alike often do not fully understand the upside to investments that incur UBIT, especially when it comes to real estate. Due to the UBIT provisions, investors are still able to leverage real estate within the IRA to expand their portfolio, and potentially their profit-making potential, beyond what would have been possible had they been required to purchase exclusively with cash from the account.

One of the biggest challenges with IRA real estate investments is that large cash purchases can significantly limit investment opportunities. Just as most homeowners did not pay cash for their primary residence, many investors do not have the cash within their IRA to purchase homes outright. The ability to leverage debt allows the IRA owner to increase holdings without having to flip the homes quickly to gain the cash for the next investment.

Example of How Debt Leverage Can Benefit the Self-Directed IRA

Let’s look at an example of a real estate IRA investment made with debt financing and how it can benefit an IRA owner in diversification and return on investments.

Your IRA property is purchased for $100,000.

• You use your IRA funds in the amount of (100,000 X 50%) $50,000 as a down payment.
• You acquire a non-recourse loan of $50,000 for the balance of the purchasing price, which represents a 50% proportion.
• Your property generates a gross profit of $500 per month or $6,000 per year.
• $6,000 X 50% = $3,000.
• The financed portion ($3,000) is officially referred to by the IRS as unrelated debt financed income (UDFI) and is subject to the UBIT.

For UBIT purposes, if the property is purchased with 50% cash and 50% in a non-recourse loan, then UBIT is only calculated on 50% of the rental income, minus expenses and depreciation. In the above example the gross profits that fall under UBIT regulations is $3,000. After the deductions for expenses, including interest and depreciation, there will likely not be any taxes owed. If there are it will be a small percentage of the total gains.

When you invest in real estate it is possible to have a net operating loss on paper, even with incoming rents, due to the depreciation deduction. Straight line depreciation is used when calculating depreciation for the property.

There is no tax due if the net income is $1,000 or less. The 990-T only needs to be filed if there are net profits of more than $1,000 if there are losses you wish to carry forward.

Any losses can be carried forward to offset future tax obligations. The losses may also be carried back for up to 2 years to offset the gains in those years, or carried forward up to 20 years.

Even when UBIT is incurred, often the profit that was made possible via the debt financing is substantial enough to offset the tax.

• First, is the ability to increase the size of the portfolio by leveraging debt financing.
• Second, the depreciation deduction can eliminate or minimize the tax obligation and in some years create a loss that will offset future gains.

Contact UBIT Professional today and learn how UBIT may factor into your investment portfolio and how we can provide a solution for your tax considerations.

Real World Example of How UDFI Impacts the Real Estate Investment

An IRA purchases residential rental property for $100,000. The terms are $50,000 from the IRA and $50,000 in a non-recourse loan.

During the first year, the property receives $11,000 in income from rents collected. Because the property is financed at 50%, the IRA would owe tax on 50% of the $11,000, or $5,500.

The $5,500 in income is reduced by any deductions allowable under the current tax code which may include interest on the loan, property expenses and depreciation. In this example the expenses totaled $4004.50, leaving only $1495.50 in UDFI. After the $1,000 specific deduction, that leaves $495.50 to be taxed at the trust tax rate of 15%, thus requiring a tax of $74.33.

In other words, the IRA investment returned a total of $5,825.67 in after-tax income. ($11,000-$5,100 (expenses) – $74.33 (taxes)).

Residential rental property depreciation is calculated as straight-line depreciation over a 27.5-year useful life. When the depreciation is calculated in, this amount is deducted from the profits that are taxable.

In the next section an example proforma analysis is provided in order to shed more light on UBIT considerations. Please note, this is merely an example proforma and should not be construed as a template to calculate UBIT in your specific situation.

Debt Financed Real Estate Proforma Accounting For UBIT

Sale of Property with UDFI

Continuing this example, the property is sold for $150,000 at the end of the year. The $50,000 loan is repaid and the profit earned from the sale is $50,000. Because 50% of the original purchase was debt financed, 50% of the profit is subject to UBIT, or $25,000 in taxable income, minus expenses.

The taxable income is taxed at the long term capital gains rate since the property is kept for one year (16%) and equals $4,000. If the property was sold in less than a year then the short term capital gains tax rate would apply, which is taxed according to the trust tax rate and is often much higher (and can be as high as 39.6%). On the sale alone, the return on this investment is $95,925.67. ($150,000 – $50,000 loan – $4,000 in taxes – $74.33 in UBIT during the first year.)

This is a 192% return on the IRA’s investment of $50,000.

The tax on UDFI is reported on Form 990-T and must be paid from the IRA.

Conclusion

As this example shows, the taxes do not significantly reduce the return on the investment, but rather enable the investor to increase the portfolio substantially more than if only cash investments from the IRA were considered. The use of debt financing enables an investor the opportunity to acquire more properties and potentially increase the returns to the portfolio by having access to additional funding in the form of debt financing.

When acquiring property with an IRA, non-recourse loans are required. The IRA cannot guarantee the loan, as required with traditional lending channels. Non-recourse lenders specialize in working with IRA investors and are willing to lend within the guidelines of a non-recourse loan. Larger down payments are often required as compared with traditional loans. However, a 50% down payment enables the investor to increase their purchasing power through debt financing.