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’s 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 unrelated business income tax (UBIT).
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When a self-directed IRA holder uses debt leverage to purchase property in his or her IRA, the debt-leveraged percentage of the IRA’s net profits (also called unrelated debt-financed income, or UDFI) are subject to UBIT. The debt ratio is calculated as an average over the previous 12 months.
Regardless of UBIT costs, utilizing a loan may allow the investor to ultimately realize higher profits than they could have without the loan. Debt leverage means an investor can purchase a property worth two or three times what they could have purchased out of pocket. A loan can also enable an investor to purchase multiple rental properties for his or her self-directed IRA.
If, after a couple of years an IRA-owned property gains value and the property owner has paid off a percentage of the debt, refinancing the property can allow the investor to reduce UDFI, thus reducing potential UBIT obligations in turn. For example, say an investor buys a $100,000 property and finances half of the purchase price ($50,000). As years go by, the house increases in value to $200,000 and the outstanding debt has now decreased to $10,000 (a 5% debt ratio 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).
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 sale proceeds of the property that can be attributed to debt leverage 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.
You can also execute a 1031 exchange to diminish UBIT obligations, which you can read about here. Please don't hestitate to contact New Direction Trust Company at 877-742-1270 or send us a message through your client portal at portal.ndtco.com.