Real estate is one of the more popular investment choices for self-directed IRA account holders. Investors can translate pre-existing knowledge of the real estate market to their IRA’s investment strategy.
Part of devising a long-term plan for your real estate IRA is understanding how refinancing your IRA-owned real estate can reduce UBIT (Unrelated Business Income Tax).
When a self-directed IRA holder uses debt-leverage to purchase property in their IRA, the debt-leveraged percentage of the IRA’s net profits are subject to UBIT. The percentage is calculated as an average over the previous 12 months.
Regardless of UBIT costs, using a loan may allow the investor to ultimately realize higher profits than they could have without the loan.
Debt leverage means an investor can purchase a property worth two or three times what they could have purchased out-of-pocket. A loan can also enable an investor to purchase multiple rental properties for their self-directed IRA.
If after a couple of years an IRA-owned property gains value, and the property owner has paid off a percentage of the debt, refinancing the property can allow the investor to reduce the percentage of profits subject to UBIT.
How It Works…
For example, say an investor buys a $100,000 property and finances half of the purchase price ($50,000). As years go by, the house increases in value to $200,000, and the outstanding debt has now decreased to $45,000 (around 22%).
If the property owner chooses now to refinance the property, the percentage of the property that is subject to UBIT will be less.
It’s important for investors to compare the new refinancing cost to the UBIT savings based on the new ongoing calculation (based on the last 12 months).
Long-Term & Short-Term Benefits
Refinancing to lessen the burden of UBIT can be beneficial for both the short-term and long-term property costs. In the short-term, the percentage of rental income that can be attributed to debt-leverage is subject to UBIT.
In the long-term, the sales proceeds of the property that can be attributed to debt-leverage are also subject to UBIT. Once an investor pays off their IRA’s loan and their debt ratio goes to zero, they will no longer have to pay UBIT on any of their profits.
IRA owners can then sell the property without having to pay UBIT on the profits from the sale. Because the property was bought with a tax-deferred or tax-free self-directed IRA account, there won’t be any capital gains taxes on any of the IRA real estate’s profits.
What If Your IRA Owns Multiple Properties?
If an IRA owns multiple properties with debt-leverage, refinancing can be especially beneficial to lessen the impact of UBIT. For instance, say an investor owns 3 properties in a self-directed IRA that he bought for $100,000 each.
This investor used debt-leverage on half the purchase price of each property ($50,000 per property = $150,000 in debt-financing). Ten years pass and now the property is worth $600,000, and the debt leverage for all three properties is down to $135,000 (around 22%).
The investor could then restructure the debt on one or more of the properties, and therefore have less UBIT to pay. Properties with better cash flow can eliminate UBIT payments, as more money coming in means more money to pay off debt-leverage.
You can read more about avoiding UBIT altogether by using a 1031 exchange here. Happy investing!