If there ever was a subject that will stop an accountant is his or her tracks, it's unrealted business income tax (UBIT). Many investors shy away from certain IRA investments out of fear that UBIT will take a big chunk out of their earnings, but these investors may simply be misinformed about the tax.
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To start, UBIT was initially placed on some taxpayers to “level the playing field” for certain businesses. The best example of how UBIT is used is for the competition between a non-profit and a for-profit enterprise. The college bookstore sells books to students and others within the structure of their “non-profit” umbrella. The college bookstore, because it is non-profit, is not taxed the same way as a for-profit enterprise. A non-profit does not pay taxes on most operations and therefore can afford to sell books at a lower cost than the for-profit store across the street. The financial advantage provided therein may allow the college bookstore to sell their books for less, thus attracting customers away from the for-profit store.
This is where UBIT comes into play. The government has placed a tax burden on the non-profit enterprise for running a business under the main business of running a college. This same philosophy and set of rules is applied to an IRA’s investment in real estate when there is debt related to the purchase of that real estate. So what is bothering the accountants among us?
These issues are resolved, however, when the investor realizes that the tax can allow for greater overall gains because the account is allowed to use debt leverage. When debating the pros and cons of using leverage within an IRA to purchase an income property, the questions could be “How much will the IRA grow using debt leverage and paying UBIT?” and “What is the resulting rate of return within my IRA?” rather than “How do I avoid UBIT altogether?” The other due diligence items such as the physical condition of the property as well as questions on the ability of the cash stream to service the loan and pay expenses, including UBIT, should also be taken into consideration.
Dismissing an investment because of the potential payment of taxes could be premature. Consult with your legal and tax advisors regarding investments involving potential UBIT within your IRA.