Understanding how Unrelated Business Income Tax (UBIT) is calculated and applied to real estate investments can help you make informed decisions in managing your self-directed IRA.
UBIT is simply a tax on income earned from mortgaged properties held in retirement accounts. UBIT should not automatically be seen as a deterrent to such investments, as it does not have to be complicated or costly. Many investors use acquisition debt, such as a mortgage, with their retirement funds to provide greater purchasing power than otherwise available, which can vastly accelerate overall portfolio growth.
How Is UBIT Generated with a Real Estate Investment?
For real estate investments held in an IRA, UBIT is a tax on income earned from the portion of real estate financed through a non-recourse loan or mortgage. Essentially, the IRS wants to tax any additional income that would not be generated but for the use of outside, non-tax deferred money. Importantly, UBIT does not affect the portion of income generated by the investment of retirement account balances.
Real estate investment income subject to UBIT - again, only the debt-financed income - is calculated in a few easy steps:
- First, calculate Average Debt.
Average Debt is simply the average monthly balance of the mortgage for the year.
Monthly mortgage payments made using your IRA, plus any additional payments made towards principle, reduce the mortgage. The average value is calculated over the months (or years) that the property has been held.
In our video example, Anna invests $250,000 of IRA funds in real estate with a 30% down payment. Her mortgage is $175,000.
Anna pays $200 in principle each month. After owning the property for six months, her Average Debt is $174,400.
- Next, determine the Average Cost Basis.
The Average Cost Basis is calculated from the first and last day the property was held during the year. The initial cost basis includes the total purchase price of the property, plus any closing fees, repairs, upgrades, etc.
This value is then reduced by the full amount of straight-line depreciation on the property for the year, if applicable.
For our example, Anna purchased her property on July 1 and incurred $5,000 each in closing fees and upgrades, for a total additional spend of $10,000.
Anna's initial cost basis is $260,000. On the last day of the year, after $5,000 in depreciation is applied, Anna's final cost basis is $255,000.
Therefore, Anna's average cost basis is $257,500 (or the sum of $260,000 + $255,000, divided by two).
- Then, calculate the Debt Financed Percentage or Ratio.
Divide the Average Debt by the Average Cost Basis to arrive at the percentage or ratio of real estate that is debt financed. This figure is multiplied against income generated by the property, as well as any deductions for interest, property taxes, repairs, or depreciation to arrive at total taxable amount.
For Anna, her percentage of debt-financed real estates is 68% after dividing her Average Debt of $174,400 by her Average Cost Basis of $257,500. Thus, her debt-financed multiplier is .68.
68% of Anna’s income of $17,000 per year is $11,560.
68% of Anna’s deductions of $10,000 is $6,800.
68% of Anna’s depreciation of $5,000 is $3,400.
Anna’s income of $11,560 minus her deductions and depreciation of $10,200 leaves Anna with $1,360 in taxable income.
- Finally, take the statutory exemption and apply UBIT tax rates.
UBIT calculations should include the $1,000 exemption all filers can take against taxable income.
If the result is greater than zero, the debt-financed income is subject to UBIT and will be taxed at these following rates (for 2020):
$0 – $2,550
Over $2,550 – $9,150
Over $9,150 – $12,500
UBIT TAX RATE
$255 + 24% of amount over $2,550
$1,839 + 35% of amount over $9,150
$3,011.50 + 37% of amount over $12,500
For Anna, this means that her taxable amount of $1,360 is reduced by the $1,000 exemption to only $360. After applying the appropriate threshold UBIT tax rate of 10%, Anna’s IRA owes a mere $36 in UBIT as a result of leveraging her IRA to purchase real estate as an investment.
As this example highlights, UBIT is either completely offset by standard expenses and the $1,000 exemption or is otherwise a minimal expense for many real estate investors. However, keep in mind that any taxes owed must be covered by your IRA from funds held in the account.
To easily calculate how UBIT might impact your current or potential real estate investment without having to do all of this math, download our free UBIT Calculator.
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