If there’s a subject that will stop an IRA investor in their tracks, it’s UBIT, or Unrelated Business Income Tax. Many investors shy away from certain IRA investments out of fear that UBIT will take a big chunk of their earnings. The truth is, the mechanisms which trigger UBIT allow investors to make bigger investments that can potentially lead to greater returns.
UBIT was initially created by the IRS to level the playing field for certain businesses. It’s not a punishment due to a prohibited transaction, nor is it illegal. UBIT is simply the cost of doing business for certain IRA investments. Many, including many financial professionals, are not familiar with UBIT. Unfamiliarity can cause alarm in an IRA investor and their financial team. When an IRA incurs UBIT as part of its investment, it’s a good thing – it means your asset is making money!
The best example of how UBIT is used in the competition between a non-profit and a for-profit enterprise. Say a college bookstore sells books within the structure of a non-profit umbrella. As such, the bookstore 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 bookstore across the street.
Since both the college bookstore and the for-profit bookstore are competing for the same customers, the college bookstore has the advantage of being treated differently for tax purposes. T he advantage of this preferential tax treatment may allow the college bookstore to sell their books for less, and therefore pull customers away from the for-profit store.
This is where UBIT comes into play. The government has placed a tax on the non-profit enterprise for running a business, i.e. selling books, 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 the property is purchased with debt-leverage. Because of the tax-advantages granted to IRA accounts, using debt-leverage to purchase a rental property with an IRA can trigger UBIT on the percentage of returns that are attributed to the debt-leverage.
However, using debt-leverage and paying UBIT can still enable an investor to realize greater overall returns on their investment. Debt-leverage may enable to invest in a larger or property or in multiple properties, and consequently receive a better payout in rent and/or when they sell the investment.
When debating the pros and cons of using debt-leverage within an IRA to purchase an income property, rather than wondering how to UBIT, investors should ask themselves “how much will the IRA grow using debt-leverage and paying UBIT?” Consult with your legal team and tax advisor regarding investments that may potentially trigger UBIT within your IRA. Dismissing an investment because of UBIT can prevent investors from ultimately realizing greater returns on their investments through a of debt-leverage strategy.
A credible self-directed IRA provider will be able to answer any questions about calculating UBIT and make the process easy. For information or videos about UBIT and other self-directed IRA issues, visit www.newdirectionira.com.
This article was written exclusively for Rentometer by New Direction IRA