UBIT, Roth IRA and a private loan

[Chris Weiler]

Let's assume I would like to purchase 200K in properties using my Roth IRA for 10% down and a private investor for the rest. These are high cash flowing properties. Assuming I have the properties in a self-directed Roth IRA LLC and use a majority of the profits to pay off the loan aggressively, I believe I can have the loan paid off in just a few years. Before the loan is paid off, I will have to pay a fair amount of taxes on profits due to UBIT. But once the loan is paid off, won't all future profits be tax free? What is your opinion on using this strategy to increase the value of my Roth IRA?

[James Harper]

DON’T BE SO AFRAID OF UBIT !!
EXAMPLE: UBIT and UDFI (Leveraging Real Estate with a Non-Recourse Loan)

Bob Smith has a Self-Directed IRA and would like to purchase a rental house for $140,000 by making a down payment of $70,000 and he leverages the property with a non-recourse loan for the other $70,000 financed at 6.5% interest only note on the difference (I am using a interest only loan for clarity on the ownership vs leverage percentage). In this example, the portion of the income and expenses subject to UBIT will be 50% ($70,000 / $140,000) because UBIT is based on the average loan to cost over the prior 12 months, if the principal balance was paid down, the percentage of leverage would also decrease.

If the gross rental income of the unit is $20,000, 50% of the gross income (based on a 50% leverage percentage) or $10,000 would be used to evaluate if UBIT is owed by the IRA and would need to be filed and paid to the IRS annually (due NLT 15MAY). All of the usual directly connected expenses are still allowed to offset the gross income, but they are proportionate to the leveraged amount. Just a quick reminder, these fees cannot be paid to the owner or any other disqualified person would be a prohibited transaction.

For the purposes of this example, I will use the following annual numbers:
Real Estate Taxes = $2,000
Insurance = $320
Property Management (10%) = $2,000
Maintenance $1,000
Depreciation $3636 (Based off $40K land, $100K structure & 27.5 years)
Interest = $4,550

So based on these numbers, your SD IRA would be looking at this for the calculation of UBIT.

$10,000 (50% Gross Income)
-$ 1,000 Real Estate (50%)
-$ 160 Insurance (50%)
-$ 1,000 Property Management (50%)
-$ 500 Maintenance (50%)
-$ 1,818 Depreciation (50%)
-$ 4,550 Interest (100% attributable to leveraged portion)
--------
$ 972 Profit for UBIT calculation.

The first $1,000 is Tax Exempt and in this instance a 990-T would not even need to be filed.

IF the leveraged portion of the SD IRA made a profit of more than $1,000, they are still taxed at Trust levels. The amounts over $1,000 are taxed as follows:
$0 - $2,300 = 15%
$2,300 - $5,350 = $345 + 25% of the amount over $2,300
$5,350 - $8,200 = $1,107.50 + 28% of the amount over $5,350

Just as a side note, in this example. The SD IRA total income after all expenses would have been $10,130 or 14.4% CoC that could be used to pay down the balance of the note or re-invested.