I have an opportunity to buy a property where the sellers are willing to keep their bank loan in place. I'm thinking of buying it with my self-directed IRA. Has anyone does this before? I have done many transactions in my IRA, but nothing with a loan on the property. I'm unfamiliar with how UBIT comes into play in this specific situation and if their would be a problem because the loan is in neither my name ot the IRA'a. Any help would be appreciated.
When an IRA uses debt financing, Unrelated Debt Financed Income is generated and taxed. This UDFI is a subset of UBIT (unrelated business income tax) and documented in IRS Publication 598.
Confer with your licensed tax advisor for specific details.
The general guideline is that the impact of such taxation on the operating income from rents is usually pretty low. The percentage of the income derived from debt-financing is taxed and you get to use the same percentage of normal write-offs like depreciation, interest payments on the note, etc. to reduce the tax amount. You will definitely see a higher cash-on-cash return to the IRA when using leverage, even with the tax cost and the cost of having a 990-T return prepared for your IRA.
If you sell the property with debt-financing still in place, the tax bite can be larger, but you should still come out ahead by using leverage.
Yes the existing loan will need to be converted to a non-recourse loan because the IRA would now be the owner of the property.
@Mark Nolan, isn't the loan already non-recourse to the buyer (ira) since it's in the name of the seller? I wanted to clarify your comment that the loan "needs to be converted" since I was thinking of doing something similar.
You are likely correct. In a subject-to deal like this, the note is still in the current owner/seller's name. The bank would have no recourse to the IRA purchaser.
The IRA would, however, still be looked at as using debt-financing, and therefore UDFI taxation would still come into play.
I have the same question. Do I need to create a non-recourse loan and wrap existing loan or just taking over loan is OK?
Taking over existing loan is okay provided it is restructured as a non-recourse loan. The loan payments would not flow from the 401k plan.
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