For almost two decades New Direction Trust Company clients have been supercharging their retirement with real estate. By purchasing real estate through their tax-advantaged account, many have also stumbled across UBIT, or Unrelated Business Income Tax. Not a penalty, UBIT is a tax on any earnings from “leveraged” real estate, a common approach to capitalizing on yield generating assets like real estate.
Ominous sounding, UBIT means that if you have a mortgage, a portion of your rental profits (the portion attributable to what you borrowed to get the property) is taxed, even though the property is in an IRA, HSA, 401(k), etc. Think of it this way: by using debt, your IRA (or other account) acquired more property than it could have otherwise, and the IRS wants to recognize some of the cash flow is not “within” the tax-advantaged account.
Now that we have introduced UBIT, we will look at five of the most common rental expenses and how you may be able to claim them to eliminate or reduce your UBIT liability.
- Management Expenses
Paying a professional management company to oversee your real estate investment can get expensive, especially if they’re taking care of everything from finding renters to orchestrating repairs. Luckily, you can catch a break on the UBIT if you claim your management expenses on your annual 990-T. If you are a New Direction client and utilize our sister company, IRA Tax Services, to file your return, there’s even better news. We can access your expense records from NDTCO to give you credit for all the allowable expenses you incurred!
- Homeowners Association Fees and Dues
While preparing UBIT returns it is not surprising to see high HOA fees. For example, annual bills of $5,000+ paid to homeowner’s associations are not uncommon (associations who maintain the neighborhood, provide community services, and sometimes remind you when your lawn needs a trimming). Thus, by including any HOA dues or similar expenses in your return, you can significantly reduce or even eliminate your UBIT tax.
All the costs of running a property paid out of your New Direction account can offset your rental income to reduce your UBIT tax bill. If your tenants cover these expenses you won’t be able to use them; however, if you are covering even a portion of gas, electricity, heating, water, or other utilities, you can include them on your 990-T.
- Maintenance and Repairs
Real estate inevitably requires repairs and upkeep to preserve its value. This is especially true regarding rental real estate, with maintenance and repairs considered a normal business expense that veteran landlords include in their cost projections. Fortunately, you can also use these repairs to offset rental income and potentially eliminate your UBIT tax. A caveat here is the expense must be for a repair, not an “improvement.” Repair expenses are the costs of bringing something back into normal or functioning condition, whereas improvements are substantial upgrades that increase the property owners cost basis instead. Increases to cost basis are also beneficial, but it’s important that they are accounted for separately.
- Tax Preparation, legal services, and other miscellaneous expenses
There are also many miscellaneous costs associated with buying, maintaining, and renting out a property that investors forget to include. For instance, legal costs, landscape design, soil analysis, furniture, and appliances can all qualify as allowable expenses, as long as they are necessary for the purchase or maintenance of the property. Although IRA Tax Services doesn’t charge an arm and a leg for the cost of preparing your UBIT tax return, it’s still nice to know that you can write off their fees as well.
The above is not a full list, of course. Other expenses can reduce UBIT, and just about any reasonable expense that you incur can be included, but it’s important that they are characterized appropriately. Feel free to give us a call or send us an email with your questions and for a quote to prepare your annual 990-T return (whether or not you are a New Direction client).