Self directed IRA: real estate income tax implications

Investing in real estate with your self directed IRA is one of the best ways to enjoy retirement returns. If your IRA does not have enough funds, you can opt to use IRA non recourse loans to help you finance the purchase. The title of the property will be owned by your IRA. Any expenses related to managing or maintaining your property will come from the IRA. If your IRA does not have enough funds to meet these, you may have to depend on non recourse financing with the property as collateral. This can result in a loss of tax benefits or penalties.


Unrelated Business Income Tax or UBIT

Properties funded by IRA non recourse loans can incur unrelated business income tax or UBIT, taxable under the IRS code. This differs from your other IRA earnings that are tax free until you take your distributions. Before you consider a real estate IRA, it would be wise to explore all the tax implications that come with a property financed by non recourse financing.

Understanding UBIT is very important because it did not come into the picture with traditional investments such as mutual funds, stocks and bonds offered by conventional custodians and banks. The income from these investments came in the form of a dividend or capital gains and were treated as passive investments, since the companies which declared the divided had already incurred a tax on their business income before the dividend was announced. Thus, your IRA account was exempt from tax until the time for taking distributions.

When your self directed IRA makes an active investment that yields an income, the income becomes taxable and incurs UBIT. Luckily, there are exceptions to UBIT for a self directed IRA especially when the investment income is from a passive source. These, among others, are:

· Interest from passive loans
· Real estate rents and rents from personal property
· Profits or losses from lapsed options to buy and sell real estate
· Profits or losses from forfeited deposits for sale or lease of real estate

Real estate rental income can still incur UBIT if the rent is from hotel rooms, parking lots, warehouses, camps, boarding houses, or rent tied to a tenant such as a shopping center’s income.

As a self directed IRA account holder, you will most likely enjoy a better rate of return from investing in real estate through IRA non recourse loans or in precious metals, etc. These do not incur UBIT. However, if you decide to rehab or flip the property or develop raw land purchased by you, it is regarded as an active business under your self directed IRA and any net profits that exceed $ 1,000 would attract UBIT.

It is important to understand how UBIT works. Often, there are excellent investments, particularly real estate IRAs with non recourse loans that give you a much better after tax returns when compared to investments that are tax free. For example, an investment with a mutual fund without UBIT may give you tax free returns of seven per cent while a real estate investment that attracts UBIT may bring you an after tax return of twenty per cent. Thus, weighing the net returns on your self directed IRA investments makes sense since these investments guarantee better returns even after tax, than the stock market.