One of the attractive features of an individual retirement account is that you don’t have to pay income tax until you withdraw money. Roth IRA withdrawals are tax-free. However, an IRA may face a current tax bill if it earns “unrelated debt financed income,” or UDFI, which is income derived from property purchased with debt.
IRAs and UDFI
To have your IRA invest in real estate, you generally must open a self-directed account with a real estate custodian. You can use this account to buy real estate and shares of a partnership or limited liability corporation that owns real estate. You must avoid transactions in the IRA that the Internal Revenue Service prohibits, such as buying, renting or selling IRA properties to yourself or family members. The IRS taxes any income other than rent generated from real estate operations as “unrelated business taxable income.”
You can hold rental property in an IRA without creating unrelated business taxable income for the IRA. However, if an IRA purchases rental property using debt, you may create UDFI. A bank or the property seller can provide debt financing. UDFI taxes apply only to the portion of rental income derived from debt. For example, if the IRA purchases property with 40 percent cash and 60 percent debt, then only 60 percent of the net rental income is UDFI. In this example, you use 60 percent of the property expenses, such as depreciation, to offset gross rental income.
First, figure the average acquisition debt for the year, which is the average amount of outstanding debt on the first day of each month that you hold the property. Next, calculate the property’s average adjusted basis for the year. The average basis is the sum of the fair market values of the property on the first and last day of the year divided by two. Divide the average acquisition debt by the average adjusted basis to find the debt percentage. Apply this percentage to the property’s net income to find the UDFI.
Suppose your real estate IRA purchases a five-unit apartment building for $1 million, which is its current average adjusted basis. You put down 20 percent, and the seller gives you a mortgage for the other 80 percent. Your average acquisition debt for the year is $798,462, and your gross rental receipts for the year are $100,000. You have depreciation and other expenses of $60,000, giving you net rental income of $40,000. Your UDFI for the year is the average acquisition debt divided by the average adjusted basis times your net income: UDFI = ($798,462 / $1,000,000) * $40,000) = $31,938.42. Use the IRS rate tables that apply to trusts and estates to figure your tax bill.
Use Schedule E of IRS Form 990-T to report your UDFI. (Do not confuse this form with Schedule E of Form 1040.) Enter the figures for gross rental income, straight-line depreciation, other deductions, the average acquisition debt and the average adjusted basis. Attach statements to show the IRS how you arrived at the numbers you write down. Enter the results in Part I of Form 990-T and Form 1040. Forward a copy of Form 990-T to your IRA custodian, who is legally responsible for reporting this information to the IRS. You might have to make quarterly estimated tax payments for UDFI.
Other UBIT Situations
You can have other kinds of unrelated business income tax arise with an IRA. For example, if you are buying and selling real estate, owning operating businesses with your IRA or using it for venture capital investments in startups, you may incur this tax.
Make sure you understand the tax ramifications of any more active investments you make with an IRA.
2018 Tax Law Changes
The 2018 tax bracket changes may impact what investments you choose to make inside or outside of your IRA, since the ordinary income tax rates are going down, meaning the tax savings from an IRA wll be less dramatic.
2017 Tax Law
Tax rates are higher for most taxpayers in 2017 than in subsequent years.
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