IRA-Debt Financing for Real Estate

[JAY21]

Are the rules the same for retirement plans and IRAs in regards to when Unrelated Business Taxable Income when there is debt-financing ? I believe under IRC 990-T and regs "some" structure of debt-financing will not automatically trigger UBTI on the rental income, but if the debt is not structured in standard fashion (i.e., variable interest rate tied to profits, or seller carry-back agreements) then it will trigger UBTI rules and not be exempt. Is this the same for IRAs ? or is any rental income earned from debt-financed property in an IRA going to be subject to UBTI.

[Guest mjb]

See IRC 408(e)(1) for applicaton of UBIT to IRAs.

[BeckyMiller]

IRC Section 514©(9) has an exemption for certain debt financed real estate, but this exemption is limited to investments of 401(a) plans and some charities. IRAs are not included in this relief.

[Guest Presbyterian]

IRC Section 514©(9) has an exemption for certain debt financed real estate, but this exemption is limited to investments of 401(a) plans and some charities. IRAs are not included in this relief.

Is the deal that the debt finance has to be non recourse? I have found only one bank in the country to do this kind of lending. If anyone has a bank besides North Ameircan Savings Bank I would love to know about it. I am a real estate investor and developer and we have lots of IRA investors buying our condos and income properties.

[Guest mjb]

why?

[John G]

Can one of our accountants provide a laypersons explaination of UBTI and how it would impact an IRA or Roth. I have seen the issue raised, but no one discusses the consequences..... account nullification? , tax impacts?

[Guest mjb]

UBIT applies to qual plans and all IRAs. Unlike Prohibited Transactions, UBIT does not affect tax exempt status of IRA. UBIT applies to capital gains or income on property which is deemed debt financed or is a trade or business carried on by a tax exempt entity under the IRC. UBIT applies if more than $1000 in income or gains is earned from the prohibited activity in a tax year. The gains are taxed at the income tax rate for trusts (up to 35% for income over $10,450) without any deductions and are paid by the exempt entity. Some states (e.g. NY and CA) have their own UBIT taxes for prohibited activities that occur within their jurisdiction. UBIT is reported on 990-T

[John G]

MJB, thank you. Let me see if I understand this correctly as it applies to Roths with "outside investments". If I participate in a real estate LLP as an "outside investment", I might end up with UBIT. While this would not void the Roth (I don't live in NY or CA), this type of income would trigger UBIT taxes if over $1,000 a year. The taxes would be paid out of the Roth, slightly above the ordinary income level (35%)?

I think this means that as long as UBIT was relatively minor, participation in the real estate LLP might still look attractive. For example, I have participated in a few LLPs in this decade for single buildings that had an IRR over 30%. An investment of 200k was completely flipped in just over 2 years when the property was sold. I shied away from using IRA or Roth funds, but it sounds like that would have been a good idea even if there were UBIT taxes, as long as they were minor. Instead, I used taxable funds and about 85% of the return was long term capital gains. I think I would have preferred to pay a minor amount of taxes on UBIT and have the oversized returns in my IRA/Roth. Other than not fully understanding the UBIT (which is still the case), the other factor is that the LLP participant has not control over how they handle the transaction and the accounting approach.

Am I presenting this application of UBIT correctly?