UBIT – It’s a Good Thing, It Means You’re Making Money!

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UBIT – It’s a Good Thing, It Means You’re Making Money!

If there was ever a subject that will stop an accountant is his or her tracks it is UBIT, which stands for unlisted business income tax. The origins of UBIT are obscure. This tax was 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. Since both the college bookstore and the for-profit bookstore are competitive for the same customers, the college bookstore has the advantage of being rented differently for tax purposes and the advantage of this preferential tax treatment may allow the college bookstore to sell their books for less , thus attracting customers away from the for-profit store.

This is where UBIT jumps in to save the day. The government has placed a tax burden on the non-profit enterprise for running a business, ie selling books, under the main business of running a college. This same philosophy and set of rules is applicable 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?

• The tax rate for UBIT is high, ranging from 26% to 34%.

• Calculation of this tax is, for those not familiar with the rules, complicated.

This sums up the issues. Now, for following through on what these issues mean for someone investing their IRA in real estate, continue reading.

Should I Invest in Debt Leveraged Real Estate with my IRA? The answer to this question is dependent on “doing the numbers”. For any investment, calculation of the rate of return should encompass all variables, including the tax treatment of the cash flow from the investment. In the case of UBIT, simply stated, it is paid on the debt-funded portion of the net income. For example, a property purchased using 100k in IRA funds and 200k in non-recourse debt would be taxed as follows:

Calculation (simplified)

Percent Debt: 67%

Net cash flow after deductions for 67% (percent of debt of total investment) of operating expenses, interest expense and depreciation, using 67% of the improvements to calculate depreciation: $ 12000

Unrelated Business Income: .67 * 12000 = $ 8000

Allowable deduction of $ 1000 applied 8000 – 1000 = $ 7000

UBIT based on maximum rate: .34 * 7000 = $ 2380

The tax of $ 2380 would have paid directly from the IRA. There are three things worth pointing our here.

1. This calculation should be part of determining the return on this investment and should be considered as any other expense.

2. This level of income MIGHT NOT have been generated if not for the leveraging power of the loan and

3. Rather than viewing this as going from 0% tax to 34% tax, it should be pointed out that if this investment were outside the IRA, it would be taxed at the normal income tax rate ranging from 25% to 28% a differential of 6% to 9%.

4. An “internal rate of return” inside the IRA should be calculated taking into consideration the advantage of the tax-deferred / free portion of the income.

Other details of UBIT calculation: the debt-financed ratio is defined as the average loan balance for the year divided by the depreciated basis. It may be in the best interest of the IRA to pay down the balance of the loan as quickly as possible, if cash is available, in other to decrease the debt-funded proportion of the Net Income that is subject to UBIT. Again, each deal must be analyzed. The cash flow from the property, rather than applying it to the unpaid balance of the debt, can be placed in another investment that offsets the burden placed by UBIT and this should also be included in the analysis of the investment.

This is a somewhat simplistic version of the actual calculation of UBIT but underestimates the magnitude of what this tax actually is. It needs to be part of a thorough evaluation of the investment.

What if I Sell? What Rules Apply?

The sale of a property that is debt leveraged is handled, for tax purposes, in two parts: the equity or IRA portion and the debt leveraged portion. The IRA portion of the sale proceeds goes directly back to the IRA custodian for reinvestment, tax-deferred and intact. The proceeds from the portion of the property purchased using debt also goes back to the IRA custodian but is taxed at the capital games rate. This tax is paid out of the IRA provided available in the account.

Qualified Plans and UBIT

UBIT applies only to IRAs with regards to debt financing. When using a qualified plan such as a 401 (k), the rules are different. UBIT will NOT apply for purchases make using leverage within a 401 (k) providing:

• The price of the property is fixed

• The financing of the property is a “new loan” and not owner-financed

• Use of the property or any claim on the property by the former owner must not exist

This is one reason that acquisition of income-producing property by a qualified plan such as a 401 (k) is more advantageous than that associated with an IRA, but there are other rules, such as those described above, that must be examined and followed before going under contract for the purchase of real estate.

Rules and Information

IRS Code Section 512 defines Unrelated Business Income, Section 513 defines what is an unrelated trade or business and IRS code section 514, specifically (C) 9 addresses how UBIT is applied to debt-financed real estate purchases by IRAs and Qualified Plans. IRS Publication 598 pulls these three code sections together in a “plain English (or Spanish)” guide more directly applicable to the calculation of UBI and UBIT.

Summary

When debating the pros and cons of using leverage within an IRA to purchase an income property, the questions should never be “How do I avoid UBIT?” but rather “How much will the IRA grow using debt leakage and paying UBIT?” and “What is the resulting rate of return within my IRA?” The other due diligence items such as 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 should never be a deal killer. Consult with your legal and tax advisors regarding investments involving potential UBIT within your IRA.

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