UNDERSTANDING UBIT How to Avoid Unintended Tax Implications in Your Real Estate IRA
E veryone knows that you don’t pay taxes on the growth of assets in an IRA, right? Well, not always. It’s true that the asset growth in the classic investments made in a Traditional IRA—stocks, bonds and mutual funds, for example—aren’t taxable until the account holder starts tak- ing distributions. And in a Roth IRA, the appreciation in assets isn’t taxed at all. But a growing number of people have self-directed IRAs, which gives them the freedom to invest in other assets. When the assets in the IRA generate income, it may be considered taxable, what the IRS calls unrelated business income taxable (UBIT). Real estate is the most popular asset bought by IRAs, both for its likelihood to increase in value and its ability to generate a reliable revenue stream through rent. That makes it important to understand UBIT. Here are a few examples that illustrate the taxable and nontaxable scenarios when an IRA owns real estate: OUTRIGHT PURCHASES: The account holder uses $150,000 of the
of ownership will increase, along with the percentage of rent it can claim as tax-deferred income. PURCHASES OF INCOME- GENERATING PROPERTY THROUGH AN LLC OR PARTNERSHIP: Often, LLCs or partnerships formed through an IRA are considered disregarded entities by the IRA and do not have to file tax returns. But not always. To avoid giving IRAs that own businesses an unfair competitive advantage over other businesses, UBIT rules may apply to income generated by these IRA-owned entities. Here are two scenarios with different tax outcomes for an account holder who uses her IRA to fund a single-member LLC (limited liability company) for the express purpose of buying income property. • Outright purchase through an LLC: The LLC buys a four-unit apartment building using $500,000 from her Roth IRA. The $50,000 in rent earned by the
$200,000 in his Traditional IRA to buy a beach house outright in an all-cash offer. The IRA collects $10,000 a year in rent. Neither the IRA nor the account holder has to pay taxes on the passive rental income received. PURCHASES MADE WITH A NON- RECOURSE LOAN: The account holder has a balance of $100,000 in his Traditional IRA to put toward the purchase of a single-family house being sold for $200,000. The IRA obtains a non-recourse loan from a lender to make up the $100,000 difference. The IRS calls this “debt-financed investment.” The house generates $24,000 a year in rent. Because the IRA owns only 50 percent of the property outright, the IRS considers only $12,000 of the rental as tax-deferred. The IRA will have to pay taxes on the remaining $12,000 in the unrelated debt-financed income (UDFI) category of UBIT using IRS Form 990-T. Over time, as the IRA pays down the principal, its percentage
20 THINK REALTY INVESTOR REVIEW
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