HOW TO AVOID TAXES INSIDE AN IRA
And Maximize Your Returns
Did you know that your IRA may have to pay taxes? Even for investments inside a Roth account?
Before I opened my first self-directed IRA investment, I thought all IRA investments were tax-deferred. Perhaps you are thinking the same thing. And when Roth IRAs were established those were supposed to be tax-free.
I found out later that certain investments in an IRA are taxed at trust tax rates, currently as high as 36 percent. Before the money is taken out.
Many accountants are not aware of this as most people stick to traditional investments in their retirement accounts.
If you are satisfied with earning 1-percent on bank CDs in your IRA then you don’t have to be concerned about taxes until you withdraw the funds. If you invest in traditional asset classes like stocks and mutual funds, you may not have an issue with taxes until you withdraw either.
But if you are investing to maximize returns, such as with leveraged real estate, then you might incur UBIT or UDFI taxes on investments in your IRA.
WHAT IS UBIT?
UBIT is Unrelated Business Income Tax. Most IRA investments grow either tax-deferred or tax-free, depending on whether they are held in a Traditional IRA or Roth IRA. But if the investment appears to be a business it may be subject to UBIT.
For example, suppose Mary has a business flipping houses independent of her IRA. She buys them at a discount, fixes them up, then sells them at retail prices. Then she decides to flip some of these inside her Roth IRA and avoid taxes. Flipping houses inside of Mary’s Roth IRA would likely subject the Roth account to UBIT.
Can Mary do a couple of houses in her IRA and not be subject to UBIT? Maybe. There is not much guidance from the IRS on how many times this could be done. But if it looks like Mary is trying to run a business inside her Roth IRA then she will need to pay the UBIT taxes.
The top tax rate for UBIT is currently 36 percent.
WHAT IS UDFI?
UDFI is Unrelated Debt Financed Income. It is incurred when you use leverage to purchase an asset in your IRA. Most IRA investments are not leveraged, but a few are and subject to UDFI tax. This tax is sometimes referred to as UBIT, but it is triggered by a different type of event.
For example, suppose Greg purchased a house for $80,000 in his Roth IRA. He then spent $20,000 on repairs to get it ready to rent. For simplicity let us assume he used $40,000 from his Roth IRA for the purchase and obtained a non-recourse loan for the other $60,000. The Roth IRA owns the house with a 60-percent loan to value, or LTV. The non-recourse loan assures that Greg has no personal liability for the loan. Rather, the loan is secured by the asset.
All cash flow from the investment flows back into the Roth IRA. Greg has the Roth IRA pay the normal expenses for property management, insurance, repairs, and the mortgage. At the end of the year the Roth IRA must pay UDFI taxes on the portion of income that is attributable to the leveraged portion. The loan is leveraged at 60-percent of the cost for purchase and initial repairs.
So if the property produced $6,000 of income in a year, then 60 percent, or $3,600 would be subject to UDFI tax. The top UDFI tax rate is currently 36 percent.
But Greg is intending to hold the property in his Roth IRA as a long-term investment, at least for a year. So the top applicable UDFI tax rate would be 20-percent.
The tax rates are graduated but reach the top rate rather quickly.
Straight line depreciation may reduce the taxable income. It is spread over 27.5 years for residential property and applies to improvements on the property but not the land.
If the property is sold, then the portion of the gain attributable to leverage will also be subject to UDFI.
HOW TO MINIMIZE THE TAX BITE
While Mary and Greg are okay with paying their fair share of taxes, neither wants to pay more than necessary. Fortunately there are alternatives. Here are a few.
Option One is to select investments that are not subject to UBIT or UDFI. Bank CDs fall into this category but do not produce the desired returns. Stocks and mutual funds are also free from the taxes, but Mary and Greg are concerned about market volatility.
Option Two is to use a different type of account for holding the asset. Assets held in a 401k are not subject to UDFI. A Solo 401k with the Roth provision can be an ideal place to hold property.
So if Greg has a business he may be able to avoid UDFI by purchasing the house, with a loan, inside a Roth Solo 401k.
Option Three is to pay down the loan quickly with the available cash flow. Each year UDFI is determined based on the average debt ratio. So if the property is paid off in the year prior to sale, no UDFI tax will be owed on the gains.
Option Four is to purchase the investment outside of a retirement account. This avoids UBIT and UDFI, but the income will be subject to ordinary income tax. And a sale can trigger capital gains taxes unless a 1031 Exchange is used.
Option Five is to be a lender. Instead of flipping a house inside her IRA, Mary could be a lender for someone else who needs money to flip a house. Her Roth IRA could be the lender and all interest would be tax-free. And the loan could be secured by a mortgage on the property, protecting her interest.
WHAT ABOUT SYNDICATIONS?
An investment in a syndication, such as to purchase commercial properties like apartments, may be subject to UDFI. A syndication will typically, but not always, purchase a property using borrowed funds. Just as in the example above with Greg, profits may be taxed based on the amount of leverage used. This can be mitigated by using funds from a 401k instead of an IRA.
Some syndications will seek to acquire properties that have a high enough profit margin that they can be obtained with cash, then make improvements and sell the property without using leverage. This also avoids UDFI.
Remember, however, the bottom line is the return on your investment. Regardless of whether or not you have to pay UBIT or UDFI taxes. In other words, if the return is high enough, you may be willing to pay UBIT or UDFI taxes.
You don’t have to stick with traditional investments in your retirement accounts. The objective is to maximize your investments within these accounts, whether you are trying to grow your nest egg or produce a stream of income to live on. Some investments will trigger UBIT or UDFI taxes, but the after-tax return may still be better than with traditional investments.
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Mike is a retired aerospace engineer with a passion for real estate investing and teaching financial literacy. He lives with his wife in Daytona Beach, Florida.