Examples of UBIT
Illustrated UBIT
UBIT, unrelated business income tax, is generated by an IRA in three ways:
1) Net income is generated by the leveraged portion of an investment at the trust rate.
2) Proceeds from a sale are taxed based on the debt balance at the time of sale at the capital gains rate (if one year or more after purchase, short-term gains are taxed at the rate of trust)
3) The IRA owns an operating business that provides goods or services. The tax is on 100% of the net income using the escrow rate.
ITU Examples
The best way to view UBIT is not a snapshot, but over several years. Most leveraged IRAs don’t earn UBIT until between years 4 and 8. This illustration shows year 1, the second shows year 8.
Summary of key points in calculating UBIT:
- Taxed on Net Operating Income * Financed Debt %
- Tax on Capital Gains on sale * Debt Financed %
- The portion financed with debt is recalculated each year.
- The tax is only a percentage of financed debt net income.
- The debt leverage percentage calculation is actually the loan balance/depreciated basis of the property
- 401(k) plans are exempt from UBIT for purchases of leveraged debt.
John’s Uncle IRA purchases an investment property through a non-recourse loan*:
First full year of operation
Cost of Ownership: $500,000
Investment IRA: $200,000
Non-recourse loan: $300,000
Leverage: 60%
Mortgage payment: $1,600/month
Taxes and insurance: $400/month
Other information:
o Rent: $2,500 per month
o Utilities: paid by tenant
o Net Cash Flow: $490/month = $5,874/year
o Depreciation: $14,545/year.
o Principal payments $4,474
o Interest expense: $14,720 (4.95%)
o Net loss year one ($4,265)
o Annual Appreciation 2.5%
UBIT is not paid
year 8
o Rent: $2,951 per month T&I $475
o Utilities: paid by tenant
o Net Cash Flow: $876/month = $10,512/year
o Depreciation: $14,545/year.
o Principal payments $6,318
o Interest expense: $12,876
o Net Income Year Eight $2,296
UBIT calculation:
o Debt balance/depreciated basis:
263,835/398,182 = 66.26%
o Net Income * 66.26% = $1,521
o UBI = $1,521-$1,000 = $521
or Taxes ~ $104
year 8
o Sale price $609,201
o Sales costs 3% – $18,276
o Net Income = $590,925
o Current year debt % financed – 66.26%
o Capital Gain ($590,925-$426,587)=$164,338
(Note $426,587 = depreciated basis)
o UBI serving $108,757
UBIT: $23,655
Gain: $164,338 – 23,655 = $140,683
A good exercise is to take the same size IRA and calculate the return on a property with no leverage. It would be difficult to determine the income generated by the rental operations, but at the end of year 8, with the same appreciation, it would be $36,370 after deducting the 3% cost of sale.
Before someone talks you out of tapping into an IRA property, run the numbers and decide for yourself. It may or may not make sense to use a mortgage, but at least YOU will understand the decisions you make when investing the money in your IRA. A self-directed IRA is the only way you can buy real estate AND have a mortgage on it. The flexibility of the self-directed IRA can give you a world of options, regardless of the direction of the numbers.