If you plan on using financing to help your IRA to acquire real estate you have walked smack dab into one ugly tax trap under the name of “Debt Financed Income”. Financing or as the tax law refers to it as “leverage” refers to obtaining a Mortgage, seller carry-back note, a private or hard money loan.
Normally income earned by an IRA is not subject to taxes, however, if real estate is purchased with borrowed funds, the income will be considered “Debt Financed Income” and the profits generated will be subject to “Unrelated Business Income Tax (UBIT).
The simplest explanation is, that the IRA is using non-IRA money to make tax deferred profits. Since the purpose of the IRA is to invest personal pre-tax contributions the use of non-IRA funds falls outside this design and results in a percentage of profits being taxed at trust tax rates in the calendar year when the profits are realized.
Here is an example, if your IRA purchased a property for $100,000, and financed $60,000 of the purchase price, the debt/basis percentage would be 60%, and so the IRA would have to include 60% of the profits as taxable income.
Lets say your profit on the sale of this single family house was $50,000 x 60% (debt basis) then $30,000 is considered “Debt Financed Income” and is subject to “Unrelated Business Income Tax” which is assessed at trust tax rates – in this case up to 39.6% which amounts to a kick in the gut tax hit totaling $10,238.00
Oh by the way, if you think you can dodge the bullet because you are going to rent the house, think again. The net profits from your rent roll are also subject UBIT each and every year– Yikes!
Wouldn’t is be great if “Unrelated Business Income Tax” could simply disappear?
This is where choosing the right type of plan makes all the difference in the world.
A One-Participant 401k plan is NOT subject to UBIT as long as the financing is non-recourse to you personally. Congress actually created a special tax code exemption for Qualified Pension Plans (401k’s) that removes them from the profit sucking UBIT vacuum an IRA cannot escape.
Choose a One-Participant 401k plan and you can gorge yourself on all the financing you want to and invest in high ROI real estate properties for wealth building. Under market value real estate investments are a great way to build wealth, and the solo 401k is the way to do it.