UBIT, Roth IRA and a private loan

Let's assume I would like to purchase 200K in properties using my Roth IRA for 10% down and a private investor for the rest. These are high cash flowing properties. Assuming I have the properties in a self-directed Roth IRA LLC and use a majority of the profits to pay off the loan aggressively, I believe I can have the loan paid off in just a few years. Before the loan is paid off, I will have to pay a fair amount of taxes on profits due to UBIT. But once the loan is paid off, won't all future profits be tax free? What is your opinion on using this strategy to increase the value of my Roth IRA?

Chris Martin

Real Estate Investor · Holly Springs, North Carolina

Pro Basic

1,045 posts
10 awards
52 influence

Aug 26 '11, 07:48 PM

Regarding "Before the loan is paid off, I will have to pay a fair amount of taxes on profits due to UBIT." That's not my interpretation of UBIT, based on Debt-Financed Property from the IRS... but I'd seek a good accountant's opinion.

This UBIT topic seems to create havoc among investors trying to leverage SDIRA accounts....

Jon Holdman

Real Estate Investor · Wheat Ridge, Colorado

Moderator Pro

12,319 posts
15 awards
95 influence

Aug 26 '11, 09:32 PM

If this was a traditional (non-Roth) IRA, the debt financed portion would be subject to UBIT. Once paid off, any profits would no longer be subject to UBIT, and profits from a sale would also not be subject to UBIT if the property was paid off at least one year prior to the date of the sale.

When you take a distribution from the IRA, however, you would pay taxes.

Its my understanding that a Roth, however, is NOT subject to UBIT at all. There are no UBIT or any other taxes on your profits nor are there profits when you take it out. That said, I'm much less familiar with Roths than traditional. If you do set up an IRA LLC, and use a good company such as Guidant to do it, they will provide detailed legal advice.

Even in a traditional IRA, all the usual deductions (expenses, depreciation, interest, etc.) still apply. So, the profits will be less than what you're accumulating in the IRA.

Jon Holdman, Flying Phoenix LLC

Ebere Okoye

Accountant · Hyattsville, Maryland

Pro

118 posts
4 awards
51 influence

Sep 02 '11, 11:31 AM

I think this is great because you have already factored in your UBTI which is at about 35%

Ebere Okoye,
Telephone: 18885023767
Website: http://www.wealthbuildingcpa.com
Ebere Okoye, WealthBuildingCPA

Chris Weiler

Real Estate Investor · Anaheim, California

105 posts
4 awards
50 influence

Sep 02 '11, 08:13 PM

Thank you all for your responses. Here is the response from my CPA.:

"If you can increase the value of your Roth IRA quicker and get a better return using leverage and velocity of money, then in our experience, generally the benefits outweigh the costs of having to pay UBIT each year for leveraged rental real estate. In your example, yes, the Roth IRA should have to pay taxes each year due to UBIT until at least the loan was paid off. The tax rate used is generally the income tax rate in effect for trusts, which currently hits 35% once the net taxable profit exceeds $11,200. So the rate can be high, but you still do get to factor in all the deductions you would otherwise normally gets (i.e. interest expense, property taxes, maintenance, insurance and depreciation as examples). Also, when looking at how much is considered leveraged for the calculation of UBIT each year, they do look at an average of the outstanding debt for the previous 12 months. So the quicker you can pay down the loan, the better it would be for the UBIT calculation."

Bill Humphrey

· Louisville, Colorado

13 posts
50 influence

Jan 02, 10:26 AM

Hi Chris,

Once the loan has been paid to -0- then the UBIT calculation is based on no leverage and thus no tax on the sale.

Note that Roth's and Traditionals follow the same rules for UBIT (and the component Unrelated Debt Financed Income or UDFI).

Also, remember that the UDFI is based only on the net profit from the taxable portion of the investment which is only the portion coming from the assets acquired with financing.

UBIT is one of the more confusing areas in the using Self Directed IRAs.

Edited: 01/02/2012 at 12:57PM by Moderator

Kyle Koller

Real Estate Investor · Chicago, IL

102 posts
4 awards
50 influence

Jan 02, 11:15 AM

Originally posted by Bill Humphrey

Note that Roth's and Traditionals follow the same rules for UBIT (and the component Unrelated Debt Financed Income or UDFI).

Also, remember that the UDFI is based only on the net profit from the taxable portion of the investment which is only the portion coming from the assets acquired with financing.

So, to the layman... If one's net rental income is zero or negative then they will owe no taxes due to UBIT? If that's the case, it makes using ira funds for leveraged RE investing way more attractive than I previously thought.

James Harper

SFR Investor · Boise, Idaho

37 posts
1 award
51 influence

Mar 12, 06:34 PM

DON'T BE SO AFRAID OF UBIT !!
EXAMPLE: UBIT and UDFI (Leveraging Real Estate with a Non-Recourse Loan)

Bob Smith has a Self-Directed IRA and would like to purchase a rental house for $140,000 by making a down payment of $70,000 and he leverages the property with a non-recourse loan for the other $70,000 financed at 6.5% interest only note on the difference (I am using a interest only loan for clarity on the ownership vs leverage percentage). In this example, the portion of the income and expenses subject to UBIT will be 50% ($70,000 / $140,000) because UBIT is based on the average loan to cost over the prior 12 months, if the principal balance was paid down, the percentage of leverage would also decrease.

If the gross rental income of the unit is $20,000, 50% of the gross income (based on a 50% leverage percentage) or $10,000 would be used to evaluate if UBIT is owed by the IRA and would need to be filed and paid to the IRS annually (due NLT 15MAY). All of the usual directly connected expenses are still allowed to offset the gross income, but they are proportionate to the leveraged amount. Just a quick reminder, these fees cannot be paid to the owner or any other disqualified person would be a prohibited transaction.

For the purposes of this example, I will use the following annual numbers:
Real Estate Taxes = $2,000
Insurance = $320
Property Management (10%) = $2,000
Maintenance $1,000
Depreciation $3636 (Based off $40K land, $100K structure & 27.5 years)
Interest = $4,550

So based on these numbers, your SD IRA would be looking at this for the calculation of UBIT.

$10,000 (50% Gross Income)
-$ 1,000 Real Estate (50%)
-$ 160 Insurance (50%)
-$ 1,000 Property Management (50%)
-$ 500 Maintenance (50%)
-$ 1,818 Depreciation (50%)
-$ 4,550 Interest (100% attributable to leveraged portion)
--------
$ 972 Profit for UBIT calculation.

The first $1,000 is Tax Exempt and in this instance a 990-T would not even need to be filed.

IF the leveraged portion of the SD IRA made a profit of more than $1,000, they are still taxed at Trust levels. The amounts over $1,000 are taxed as follows:
$0 - $2,300 = 15%
$2,300 - $5,350 = $345 + 25% of the amount over $2,300
$5,350 - $8,200 = $1,107.50 + 28% of the amount over $5,350

Just as a side note, in this example. The SD IRA total income after all expenses would have been $10,130 or 14.4% CoC that could be used to pay down the balance of the note or re-invested.