This time of year has me thinking about the end of the year issues like taxes and how the IRS treats investments in IRAs that are subject to income taxes. You might ask the question, “I thought IRAs didn’t have to pay income taxes until withdrawals are made?” Well, there are instances where income taxes are due and that is when there is debt financing used in an IRA, and the investment within the IRA makes a profit. The income is called unrelated debt-financed income and the tax due is called UBIT.
So what is UBIT?
UBIT is the acronym for unrelated business income tax. Congress in the 1950s created the tax to level the playing field between non-profit entities and private enterprise when non-profits were competing directly with private enterprises in an endeavor unrelated to their original mission. Hence the term unrelated business income tax. For complete details of UBIT and how to file, I would refer you to your accountant and IRS publication 598. Pub 598 details the scenarios under which UBIT applies. And since we are lenders, not accountants or financial advisors, I recommend you visit with your accountant to help you prepare IRS form 990-T required of all IRAs filing UBIT.
To give you some insight into this tax, here is how it works. If your IRA owned a duplex outright (without debt), there wouldn’t be any income tax due on profits from rental income. But there are taxes due on this same duplex, on profits made to the extent of the acquisition indebtedness on the property. If there is a 50% average acquisition loan balance on the property during the year, then 50% of the net profit (after all expenses) is taxable at trust tax rates. So, if after all property taxes, insurance, mortgage interest, maintenance, homeowner association dues, management, depreciation, and other expenses are taken out of the property during the year, and the bottom line figure is a profit of, say, $3,000, then 50% of the $3000 or $1500 is subject to UBIT. Bear in mind, there is a $1000 specific deduction, so you may in fact only have a tax on $500 of the profits. There is a wonderful example in IRS Publication 598 on the computation of debt-financed income, and I would encourage you to read it or have your accountant do so and explain it to you. Suffice it to say, there are circumstances where income taxes are due within an IRA and you need to be aware of them.
Hopefully, this will not dissuade you from using a non-recourse loan to purchase investment properties with your self-directed IRA. The tax is real, but not onerous, and the amount of the tax is based on the amount of money you borrow. The less you borrow, the less you pay. I guess the real issue is this: Would you rather have to pay some income tax on an investment where the majority of the income is tax-deferred (or tax-free in a Roth IRA) or pay income taxes on all your profits if you owned the same investment outside your IRA? Once again, I think the benefits to self-directed investing are clear.
First Western Federal Savings Bank employees are not accountants, nor are we investment advisors, and we are not qualified to provide advice on IRS rules, regulations or eligibility requirements. Please consult your tax and investment advisors.
For more information on home equity loans, refinancing your non-recourse loan, purchasing vacation rental properties, and more, browse through our website and as always, don’t hesitate to reach out to our non-recourse lenders! We look forward to hearing from you, and can answer any remaining questions you have about the non-recourse loan application process.