Borrowing money to buy property through your IRA can create a tax obligation you might not expect, even if you have a Roth IRA. David and Tom Moore, The 1031 Exchange Bros., explain how UBIT (Unrelated Business Income Tax) on IRA real estate affects purchases made partly with borrowed money. To avoid that financing-related tax, they show how you can buy property alongside your IRA using personal funds instead.
How Borrowing Can Trigger UBIT on IRA Real Estate
Let’s say you find a property you want to buy, but your IRA has only enough money to cover half the purchase price. You borrow the other half. Now you have two sources of money funding that investment: your retirement funds and a loan.
In this 50-50 example, roughly half of the property’s net operating income (rental income left after operating expenses) would be subject to UBIT because half of the purchase was funded with borrowed money. The tax applies to the income associated with that financing, rather than the portion purchased with your IRA’s own funds.
Does a Roth IRA Avoid This Tax?
You might be thinking, “But I have a Roth IRA. My money grows tax-free. Why would I owe this tax?”
On the portion purchased with your Roth IRA funds, you still have the Roth’s tax treatment. But if you borrow to cover the rest of the purchase, that loan is not your Roth money.
Take the same 50-50 example. Half of the purchase comes from the Roth IRA, and half comes from financing. The income associated with the borrowed half can still be subject to UBIT.
So the question is not just, “What kind of IRA do I have?” It is also, “Where is the money coming from to buy this property?” A Roth IRA does not remove the tax associated with financing.
Buying Alongside Your IRA With Personal Funds
Now suppose you have the money to cover the difference personally. You do not want to borrow, and you do not want the UBIT that comes with borrowing. Can you put your own money into the purchase?
Yes, and this arrangement is called tenant-in-common ownership, where you and your IRA’s investment entity own separate shares of the same property. In this example, that entity is an IRA-owned limited liability company, or IRA LLC.
You put in half the purchase money personally, and the IRA LLC puts in the other half. Your money buys your share of the property; the retirement money buys the IRA LLC’s share. You are buying alongside the IRA, rather than putting personal money into the retirement account.
From there, the income follows the ownership. You receive half of the property’s net operating income and pay the applicable personal income taxes on it. The IRA LLC receives the other half, which can grow tax-deferred in a traditional IRA or tax-free in a Roth IRA. With no borrowed money funding the purchase, you avoid the UBIT associated with financing.
When the property sells, you also have a choice about your personally owned share. You can sell, receive your proceeds, and pay the taxes. Or, if you want to keep investing in real estate, that tenant-in-common interest may qualify for a 1031 Exchange into another investment property, allowing you to defer those taxes.
How You Fund the Purchase Makes a Difference
Buying real estate through an IRA does not automatically keep all of the income sheltered from taxes. Using borrowed money alongside IRA funds in real estate investments can create UBIT, even with a Roth IRA.
If you have personal funds available, purchasing your own share of the property alongside your IRA offers a way to complete the purchase without triggering UBIT from borrowed money. You still pay applicable taxes on the income from your personal share, but the income belonging to your IRA stays in the account, where it can grow tax-deferred in a traditional IRA or tax-free in a Roth IRA. That personal ownership can also open the door to pursuing a 1031 Exchange for your share when you sell the property, which gives you the opportunity to defer taxes on that gain while you continue to grow your investments.
If you are considering buying property alongside your IRA, contact IRA Advantage today to discuss how the ownership structure may affect your tax obligations and future 1031 Exchange options.
The Guys With All The Answers…
David and Thomas Moore, the co-founders of Equity Advantage & IRA Advantage
Whether working through a 1031 Exchange with Equity Advantage, acquiring real estate with an IRA through IRA Advantage or listing investment property through our Post 1031 property listing site, we are here to help Investors get where they want to be. Call them today! 503-635-1031.
FAQs About IRAs and UBITs
What triggers UBIT on IRA real estate?
Borrowing for an IRA’s property purchase can trigger UBIT on the income associated with the financed portion. In the 50-50 example, roughly half of the net operating income would be subject to the tax.
Does using a Roth IRA eliminate UBIT?
No. Roth IRA funds retain their tax treatment, but borrowed money does not become Roth money. Income associated with the loan can still be taxable.
Can personal funds help avoid UBIT from financing?
Yes. In the tenant-in-common example, you use personal funds to buy one share of the property, and your IRA LLC buys the other. This avoids borrowing, though you still pay applicable taxes on your personal share of the income.
