Understanding the Ins and Outs of Unrelated Business Income Tax Helps in Devising a Debt-Reduction Strategy

Real estate is one of the more prominent investment choices for account holders of self-directed IRAs. Investors can translate pre-existing knowledge of the market to their IRA’s real estate investments. In order to devise the optimal investment strategy for your IRA’s property, it’s important to understand the short- and long-term benefits of utilizing a loan, and the mechanics of the UBIT (unrelated business income tax), a special tax applied to profits derived from an IRA loan.

While UBIT may sound unappealing at first blush, it’s important for investors to do the numbers when it comes to the benefits of utilizing a loan in conjunction with the cost of UBIT. By understanding how unrelated business income tax affects your IRA, you may be able to develop a winning debt-reduction strategy that potentially maximizes your retirement savings.

When you debt-leverage a real estate investment for your IRA, you can buy an investment property worth two or three times more than your current IRA balance, all while allowing a tenant to pay off your IRA’s debts (and possibly provide additional cash flow) through rental income. You can combine the benefits of a loan with the tax-deferred or tax-free income rules associated with IRA accounts. Although the debt-leveraged percentage of your IRA’S net profits are subject to unrelated business income tax, utilizing a loan for your investment may ultimately allow you to realize higher profits than you could have without the loan.

In regard to the short-term benefits, keep in mind that the non-debt-leveraged percentage of your IRA’s profits are not being taxed at all, due to the fact that profits from IRA contributions grow tax-deferred if it’s a traditional IRA, or tax-free if it’s a Roth IRA. Rental income can help reduce your debt ratio by accelerating your principal payments (via profit from rent) and, by extension, reduce the percentage of your profits that are subject to UBIT.

The tax deductions associated with personal real estate investing (e.g. depreciation, mortgage interest, repairs, etc.) can also offset taxable UBIT profits. In other words, if your 12-month average debt ratio used to calculate UBIT is 50 percent, you may offset that taxable income with 50 percent of deductions. In the short term, you can use expenses to offset income and lessen the percentage of profits that are subject to unrelated business income tax. The less taxable profit you have, the more money you can make for your IRA.

To realize long-term benefits of debt-leveraging your real estate IRA, once you pay off your IRA’s loan and your debt ratio calculates to zero (by averaging the last 12 months), you will no longer have to pay UBIT on any of your profits. You can then sell the property without having to pay UBIT on the profits from the sale. Because the property was bought with a tax-deferred or tax-free IRA account, there are no capital gains taxes on any of the real estate IRA’s profits.

Depreciation provides investors with tax breaks each year throughout the life of the investment property. When you purchase property outside an IRA, you must recapture the depreciation of the property upon the sale of the home. A little-known detail about depreciation and IRA real estate is that once the debt ratio of your investment property’s loan calculates to zero (over the last 12 months), you no longer have to capture depreciation upon the sale of the property. This fact can significantly influence your IRA real estate investment strategy, as keeping the benefits of yearly depreciation without having to recapture can provide investors with a huge advantage.

Run the numbers for your investment to determine which IRA real estate strategy will be the best fit for you. You can enlist the experience of a tax or accounting professional to help you calculate your debt percentage and your potential UBIT percentage.

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  • Clay Malcolm

    Chief Development Officer Clay Malcolm oversees most avenues of marketing, teaches continuing professional education and informal classes and webinars, and facilitates the training of business development and client representative teams at New Direction IRA Inc., a self-directed IRA provider that assists more than 12,000 clients nationally. Malcolm, who has more than 20 years’ management experience in various roles, draws upon his teaching background to develop the educational aspects of New Direction IRA and impart knowledge about self-directed IRAs to its clients and prospective clients. Malcolm received his Bachelor of Science degree in Communications from Northwestern University. www.newdirectionira.com/education

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