Self-directed investing through IRAs and Health Savings Accounts allows you to defer (or eliminate) tax until withdrawals. However, pairing equity investments with debt financing may incur unrelated business income tax (UBIT), even when the equity is provided by a tax-advantaged account.
The most common instance is leverage financed real estate. If your account borrows money to purchase property, your account may owe UBIT on a portion of the earnings generated by your property, including at the sale. As a simplified example, if you sell a property that’s 50% debt financed, half of the property’s profits will be subject to UBIT. See below for more information on UBIT.
Fortunately, like many other taxes, you have an option to defer UBIT – 1031 exchanges.
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What is a 1031 Exchange?
1031 exchanges allow investors to defer taxes on property sales if the proceeds are rolled into another, like-kind property. This also applies to the UBIT that would be owed by any gains on the sale.
There is currently no limit to the number of 1031 exchanges an investor can execute. Further, not only can a 1031 help defer UBIT at sale, but it can also help you gradually eliminate it.
It works like this: the more 1031 exchanges you make, the more time you have to pay off the debt (assuming no refinancing strategies). As you lower your debt to equity ratio, the lower your UBIT obligations become. Once the real estate mortgage is completely paid off, you won’t have to pay a penny of UBIT.
If diminishing debt isn’t an immediate concern, you could apply the funds from one property to multiple additional properties. For instance, let’s say you receive $250,000 from the sale of your IRA-held house. You could allocate $125,000 to two other properties and grow your portfolio, all without having to pay taxes.
What are the Rules?
The like-kind standard is key with these transactions. In this regard, “like-kind” simply means an exchange of one investment property for another. You could swap a rental condominium for a piece of raw land, a fix-and-flip house, etc. You would not be forced to purchase another condo with your condo proceeds. You cannot, on the other hand, exchange an investment property for a property you’ll use as a personal residence. As long as one investment is rolled into another, you’ll be following the like-kind rule.
Furthermore, investors should bear two important time frames in mind:
- 45-Day Rule – Once the first investment property is sold, you have 45 days to identify the next investment property.
- 180-Day Rule – The entire exchange and all applicable transactions must be completed within 180 days.
Note that the clock starts on both time frames once the initial sale is done.
Get Answers When You Need Them
You may benefit from a conversation with your accountant or tax professional when considering a 1031 exchange. For UBIT, New Direction Trust Company built an investor-friendly calculator to help determine the potential impact of UBIT, should it apply. For many, the amount is quite small relative to the value of the property. Additional information can be found here.
For matters related to your self-directed plan, call NDTCO at 877-742-1270 or reach us through the Client Portal.