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Do You Owe UBIT Tax On Your Investment Property?

calculating UBIT

If you’re an investor who is using an IRA to purchase investment properties, then you could be in for an unpleasant surprise.

According to the IRS, if you use a self-directed IRA or 401K plan to buy raw land or commercial property, all gains are tax-deferred until you withdraw money from the account.

But for investors who purchase more than one property in a year, or use leverage to purchase properties, these multiple investments could take them out of the personal category and into the business category – which is when the UBIT rules apply.

In particular, if you use your IRA to purchase a property, and the property is financed by a non-recourse loan, then the part of the loan that is debt-financed may be subject to UBTI.

That’s because the IRS views the IRA as funding an active business, and according to the IRS, any income from a business that isn’t “substantially related” to the retirement account – the business – is taxable.

And although the tax was originally created in order to prevent tax-exempt companies from getting out of paying their taxes, it also affects investors or those who own retirement accounts that invest in commercial real estate frequently.

How To Tell If Your Investment Owes UBIT

As stated earlier, any account that uses IRA funds to purchase a property is liable to pay UBIT taxes. This also includes LLC’s or partnerships.

So let’s say you use your IRA to put a 50% down payment on a triple net that costs $500,000.

That means you’ll receive a non-recourse loan for $250,000 of the purchase price.

calculating commercial property taxes

If the property generates $3,000 a month, then $1,500 of this amount is called by the IRS unrelated debt-financed income, and thus is liable for UBTI taxes. This means the total amount subject to UBTI taxes is $18,000 a year.

There is one saving grace though. UBTI taxes only apply expenses, including interest and depreciation, are deducted, so the actual amount owed will be less than the unrelated debt-financed portion.

How Do You Pay the UBIT?

Since technically it’s the IRA that owes the tax and not you, the account holder, it is the IRA that must pay the tax. In addition, UBIT tax rates are equal to corporate tax rates, and so the amount owed will be higher too.

However, if there isn’t enough money in the IRA to pay taxes owed, you can pay for the tax personally, and the IRS will view the payment as a contribution. Otherwise, you can either sell an investment, or rollover money from another retirement plan.

UBTI Also Applies To Income Property Sales

UBTI applies to both purchases and sales, so if you sell an investment property that was financed with debt, you’ll still need to pay UBTI taxes.

Thus, using the earlier example, if you turned around at a later point and sold the triple net lease property for $600,000, you’ve made a profit of $100,000. And since 50% of the property was financed with debt, 50% of the profit becomes subject to UBTI. This means that $50,000 of the amount received will be subject to UBTI.

calculating UBIT tax

The tax rate will depend on how long after the purchase the property was sold. If it was less than a year, then short-term capital gains taxes will also apply, which can be as much as 39.6%.

At first glance, it may appear that using an IRA to fund a triple net lease property is a risky proposition. However, there are still plenty of reasons why using an IRA to purchase an investment property is a good idea.

Most importantly, however, leveraging funds in your IRA allows you to use leverage to buy more properties. That’s because instead of cash sitting in an account making 2% – 3%, you can take those same funds and put them to work earning anywhere from 5%-7% a year with a triple net lease.

Triple net lease properties are also safe, liquid investments, so in the event that you decide to use the money elsewhere, it is easy enough to sell the property within a short amount of time and regain your funds back – usually with a bit of profit added.

The more triple net properties you own, the more you can use the resultant streams of income to pay off properties purchased earlier on. And once those properties are paid off… you can buy more triple nets, continuing the cycle of success.

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Tags: commercial income, commercial real estate, commercial real estate investing, income tax, IRA, IRS, triple net lease, UBIT