What is UBIT and what does it have to do with your self-directed IRA real estate investment?
I have come to the conclusion that it is usually how well reality meets our expectations of how things will go versus what actually happens that determines our experience of things. So, knowing what to expect is generally pretty important to the greatest extent possible. One thing I find that some real estate investors are unaware of, and thus not expecting, is the possibility of incurring an additional tax on their IRA if it is invested in certain businesses or leveraged real estate investments. What? Tax on my IRA? The IRS put in place some rules to account for what was considered an unfair advantage for benefiting from the growth of your money within an IRA to the extent that benefit was due to leverage. After all, that leverage was not actually money you contributed to your IRA yet you are benefiting by making a profit from that portion of leverage within your IRA. That is what is referred to as Unrelated Debt Financed Income (UDFI) which creates the Unrelated Business Income Tax (UBIT) .The same UBIT tax can apply to investments made in businesses that operate as pass-through entities and thus are not themselves taxed at the entity level; this income is referred to as Unrelated Business Tax Income (UBTI).
As it relates to real estate, 3 common scenarios in which the UBIT tax might be incurred by real estate investors are:
1. Using your self-directed IRA to purchase a property with a mortgage: In this case, UBIT would only apply to the portion of the net income that came from the debt financing. You would still be able to utilize deductions like property expenses and depreciation to reduce that income which is subject to UBIT. UBIT would also apply to the profits received upon the sale of such a property in proportion to the debt financed part of the investment.
2. Using your SDIRA for fix-and-flip projects: Using your IRA to purchase, renovate, and flip real estate can also generate the UBIT tax even if there is no leverage (mortgage) on the property, as it is considered an ongoing business by IRS standards and thus generating Unrelated Business Tax Income (UBTI).
3. Using your SDIRA to invest in leveraged real estate syndications: Just like the purchase of an individual property like in the 1st example, an investment with your SDIRA into a syndication which uses debt financing for that purchase (which is usually the case), your net income and profit upon sale will also be subject to UBIT in proportion to the leveraged amount. Again, the income subject to UBIT is NET of the typical expenses associated with the operation of a property as well as the depreciation deduction.
So does this mean you shouldn’t use your SDIRA to invest in any of these ways? No, not at all. First off, like in the case of an investment within or outside your IRA, many times the deductions you are able to take make the taxable income quite low or even negative (paper loss), so the UBIT could end up being something quite nominal or zero. Even if not zero, you always have to look at the overall picture of how much you are gaining not just the amount of a tax. As they say, don’t let the tax tail wag the dog.
As a side note, another option to consider when contemplating self-direction of your retirement funds is the fact that investments within self-directed Solo 401k’s are NOT subject to UBIT as a result of Unrelated Debt Financed Income (UDFI). There are situations where a Solo 401k can still be subject to UBIT, but this distinction is just related to UBIT generated by using leverage within the investment which is obviously pretty common within real estate.
As I always like to point out, I am NOT a tax professional and am only providing you ideas to think about and discuss with your own tax and legal professional advisors. Each person’s investing and tax situation is unique and I am by no means a tax expert. I have just found this topic particularly useful to point out to investors who are interested in self-directing their retirement funds and wanting them to have the best experience by knowing what to expect and what to discuss with their own tax advisor.
Feel free to leave any additional advice based on your own experience using SDIRA’s or Solo 401k’s for your real estate investing.