Real estate is a common investment choice for self-directed IRA account holders. Investors can translate pre-existing knowledge of the real estate market to their IRA investment strategy. Part of devising a long-term plan for your real estate IRA is understanding how refinancing your IRA-owned real estate can reduce UBIT or unrelated business income tax.
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When you use leverage to purchase property in your IRA, the debt percentage of the IRA’s profits may incur UBIT. The debt ratio is calculated as an average over the previous 12 months.
Utilizing a loan may enable the investor to realize higher profits than they could have without the loan. Debt allows an investor to purchase a property worth more than what they could have otherwise afforded. A loan can also enable an investor to purchase multiple rental properties for his or her self-directed IRA.
How to Reduce UBIT
If a property gains value and the owner pays off a percentage of the debt, refinancing the property can allow the investor to reduce potential UBIT obligations. For example, say an investor buys a $100,000 property and finances half of the purchase price ($50,000). Later, the house appreciates to $200,000, and the outstanding debt decreases to $10,000. The debt ratio is now 5% versus the original debt ratio of 50%). If the property owner chooses to now refinance the property, the percentage of the property which is subject to UBIT will be less. It’s important for investors to compare the new refinancing cost to the UBIT savings based on the new ongoing calculation (which, again, is based on the previous 12-month average).
The Benefits of Refinancing
Refinancing to lessen the burden of UBIT can be beneficial for both short-term and long-term property costs. In the short-term, the percentage of rental income that can be attributed to debt leverage is subject to UBIT. In the long term, the property sale proceeds attributable to debt are also subject to UBIT. Once an IRA loan is paid off and the debt ratio calculates to zero, UBIT will no longer apply. IRA owners can then sell the property without having to pay UBIT on the profit. Because the property was bought with a tax-deferred or tax-free self-directed IRA account, there will also be no capital gains taxes.
If an IRA owns multiple properties with debt leverage, refinancing can be especially beneficial to lessen the impact of UBIT. For instance, say an investor owns three properties in his or her self-directed IRA, which they bought for $100,000 each. This investor used debt leverage on half the purchase price of each property ($50,000 per property = $150,000 in debt-financing). Ten years pass, and now the real estate is worth $600,000, and the debt-leverage for all three properties is down to $135,000 (around 22%). Restructuring the debt could result in the payoff of one or more mortgages and consequently increase cash flow from the best performing property. Additionally, properties with better cash flow can eliminate UBIT payments, as more money coming in means more money to pay off debt leverage.
Understand Your Options
You can also execute a 1031 exchange to reduce UBIT obligations, which you can read about here. Please don’t hesitate to contact New Direction Trust Company at 877-742-1270 or send us a message through the Client Portal.