Self directed IRA monies

16 Replies

I am curious, if you use a self directed IRA in a BRRR strategy, when you refinance the house, can you take some of the proceeds out as cash; or, does it all have to stay in the IRA?

@Mark DiPietro

All funds would need to remain in the IRA.

When using a self-directed IRA, it is not YOU purchasing the real estate using tax-free money. Rather, the IRA is the purchaser.

The IRA will own the property, and the IRA will be the borrower on the note. The note must be non-recourse, meaning no personal guarantee from you.

The IRA can use the equity pulled out of a BRRR property to acquire additional investments. This can be a powerful growth strategy for your retirement savings.

@Mark DiPietro

When you finance property using IRA the loan must be non-recourse as Brian mentioned above. There is only handful of lenders who offer such loans. You should be able to do a cash out refinance but most of this lenders have seasoning requirements, meaning that they will use purchase price (not appraised value) as the value of the property when you refinance before there seasoning period which might be two or three years. Here is a list of lenders offering such loans, contact them to see if their programs will work for you:

https://www.biggerpockets.com/blogs/2810/50272-list-of-non-recourse-lenders-for-self-directged-ira-and-401k

@Mark DiPietro   Quick answer; NO you cannot take out cash. It all needs to stay in the IRA

Now if you are old enough to take distributions, I suspect you could take out some of the money. (see caveat below) If you are not old enough to take out distributions they you would pay a penalty for taking out the money. 

If you borrow money in an IRA, it is subject to UDFI (Unrelated Debt Financed Income) This is a high tax and basically negates any advantage to using the IRA. So even if you are old enough to take distributions the money you take out will likely be subject to that tax.

@Ned Carey

Your characterization of UDFI as a high tax that negates the benefits of using leverage in an IRA is simply not accurate.

The rate itself can get high if you are working with significantly large amounts of IRA capital - but even then will apply to only a small fraction of the income produced by an IRA investment property that is debt-financed. Most investors in the $100K - $300K range - which is most IRA investors - will see a nominal impact through taxation on UDFI.

We have run the analysis many times for investor clients over the years. The small cost of UDFI taxation is negligible relative to the significant improvement in cash-on-cash return an IRA will experience when using leverage as opposed to investing all-cash.

Remember, when speaking of IRA investments, one must compare against other investments the IRA may make, not against investments you may make separately with non-IRA dollars.

@Brian Eastman I was only going by what my accountant told me. Are UDFI and UBIT the same rates? From your post is sounds like the rate vary. Is that true? Thanks.

@Mark DiPietro

All the funds have to flow through the IRA because the IRA made the investment. However, If you take distributions federal, and possibly state taxes will apply in addition to a 10% penalty if you are under age 59 1/2 at the time of the IRA distribution.

Thank you all so much for the responses.  I really appreciate the information.  Based on my age and the amount in this particular account, it might not be worth it yet.  

Again, thank you!!!

@Ned Carey fron what I understand of the IRS tax code UDFI is a lower tax rate than UBIT depending on the amount. I believe UBIT can follow the normal income tax brackets whereas UDFI can follow capital gains? I've been trying to figure that out too as I am doing the same thing with ny SDIRA. However if you take money out its a distribution and you pay the penalty, so best to just not do it.

@Ned Carey & @Joe Arida

Unrelated debt financed applies in two ways; to the operating income of a debt-financed property, and on the gain at sale of the property if there is still debt-financing in place.

Ned's CPA is not entirely incorrect in his statement that the rate can be high, as IRA's are taxed at trust rates which scale to 36.5% at about $12,400 of income. These rates would apply to the net taxable operating income from a leveraged rental. The sale of property will be taxed at a lower 20% capital gains rate.

The key thing to understand, however, is that the net taxable income will generally be a small fraction of the gross income produced by a leveraged rental.

Here is a quick and dirty run of numbers.

$200K rental property purchase, using $100K IRA down payment and $100K non-recourse loan.

Rents for $2400 per month, or $28,800 per year.

Property is 50% debt financed, so 50% of the gross income ($14,400) is viewed as taxable.

You then reduce the gross taxable amount with a $1,000 exemption and then 50% of normal deductions including interest payments on the note, straight line depreciation on the property, operating expenses like property taxes, insurance, repairs, etc.

With operating expenses of about 30% of gross income, the net UDFI taxable income would be about $4,800 and the tax would be about $700.  That $700 is a small dent in your overall return, which is considerably boosted by the use of the borrowed funds.  

If a property is sold while there is still debt-financing in place, then the ratio of income attributable to the remaining financing is applied. Generally, the debt-financing ratio will decrease over time as the mortgage is paid down, so depending on when you sell, it could be considerably less than the initial 50% as in the above example. It gets difficult to illustrate that without running a 10-year proforma analysis or thereabouts, but again, the net result to the IRA is positive. Sure, you give up some of the gain on sale to taxation, but you are selling an asset with a valuation that is proportionally higher due to the use of borrowed funds. The cash-on-cash return to the IRA is still going to be a good number if it is a good deal.

This analysis is a bit high level (it is late on a Sunday evening), but hopefully illustrates the point that paying a little bit of taxes to benefit from leverage in an IRA is a net positive.

Far too many people here there is taxation inside of an IRA when debt-financing is used and turn the other way without doing a proper analysis. This is selling the potential of your IRA short.

@Brian Eastman  

Thanks again for your excellent explanation of UDFI! I'm working the numbers right now and have a good understanding of your example. I am trying to determine if--from a tax perspective--it would potentially be better to have two properties at 50% and have that subject to UDFI (and potentially UBIT?), or buy one property cash within my SDIRA LLC and not have the UDFI--and if so, quantify how much better. I think it would be, but I have a couple questions below.

  • I see you didn't mention UBIT at all in your example. In that example, does UBIT not apply? I can't find a good example of UBIT that doesn't assume one already knows what UBIT is (basically saying, person A has $1000 of UBIT income--okay, great, but what is an example of UBIT income?
  • Does the UDFI tax get paid out of the IRA account, or do you pay that out of a personal account? Or is this a "it depends" sort of thing...?
  • "You then reduce the gross taxable amount with...50% of normal deductions" -- If you leveraged at 75%, then all your deductions would be 25% of the normal deductions because that is your interest % in the asset?
  • If you have a lot of deductions, can you deduct more than your taxable amount and pay no UDFI taxes at all? I'm translating your numbers into an deal I was looking at and trying to determine if I'm working it correctly. I've got a spreadsheet I could upload to google docs if you or anyone else is interested in looking at it (if not, no worries :)
  • If you were to partner with your own IRA to purchase a property, say 50/50. It sounds like a headache I'd rather avoid, but I'm trying to understand all the options. I understand this ownership ratio can never change nor can you sell to disqualified persons, etc. All expenses must be paid proportionally out of the separate accounts, and you still cannot do work on the property. Regardless, if one were to do such a thing, would my personal 50% of cash flow be subject to any additional taxes? Would that be considered UBIT then?

No rush at all! I'm just working numbers and trying to make sure I am understanding this correctly :) I realize that UDFI isn't a huge amount, but when looking at actual cash flow after expenses, it can really make you take a big hit. When running numbers on a deal I saw cash flow go from $120 down to $20. Granted, I am probably not factoring in ALL the deductions I possibly could, but it's definitely something to be considered carefully.

@Joe

Debt-financing will reduce your cash flow, but increase your overall dollar-for-dollar return on investment. This is true both inside and outside of an IRA.

There is a calculator available in the learning center of our web site that would probably help you out.

UBIT is the tax paid. UBIT liability is generated from UDFI (debt financing) or UBTI (trade or business income) in an IRA. Rental income is passive and therefore not considered UBTI. It is a complex alphabet soup.

UBIT tax on UDFI is paid from the IRA. This does not intersect with your personal return in any way.

You reversed the deduction ratio in your example. One determines the debt financing ratio based on how much debt is used. If a property is 75% debt-financed (not realistic with non-recourse lenders that will typically only go to 60% LTV at most) then 75% of the income is considered taxable and 75% of the normal deductions are applied to offset that income.

It is possible that if deductions negate income there can be a zero or negative tax.  A negative tax amount can be carried forward, so you still want to file.  You would rather not have those expenses and a more profitable property, however.

Do not partner with your IRA and yourself - especially when debt is used. I can pretty much guarantee that particular scenario would create a prohibited transaction. If the IRA were to joint venture on a deal with someone who is not a disqualified party, the IRA would receive its overall percentage of income, costs and taxation and the partner would separately have their own portion they would treat appropriately - whether also in an IRA or personal.

In a leveraged deal, a good bit of the "income" is the equity created by paying down the principal on the note.  You do not see that as cash flow, but rather when you sell the property.

Brian, my understanding is that there is a ratio to determine how much of the financed investment will get hit with UDFI. I am delighted to learn from you that the amount is negligible! If I use a self-directed IRA to buy a property with 80% financing, how can I determine the amount of UDFI tax? Thanks so very much

@David W Stults

The best way to determine impact of UDFI on a deal is to consult with a licensed tax professional.  

We do have a UDFI calculator on our website you can reference to get a rough idea.  BP does not like us to direct link such outside resources, so you'd just need to visit the learning center and look for it.