Entrust Learning Center > 5 Investing - Real Estate > Exchange Away the Debt-Financed Tax Consequences of a Leveraged Real Estate IRA (The Adventures of Tex Free)

Exchange Away the Debt-Financed Tax Consequences of a Leveraged Real Estate IRA (The Adventures of Tex Free)

By: Mark Hodges

IRA and 401(k) Insights

More and more folks are hearing of, learning about, and acting upon the emerging investment opportunities available through fully self-directed real estate IRAs and 401(k)s. They are realizing that their investment choices do not have to be limited to the conventional fare of stocks, bonds, and mutual funds. Rather, they are investing IRA and 401(k) dollars in real estate, private loans, private companies, and a host of “alternative” opportunities while reaping the increased rewards of tax-deferred (or tax-free) returns within their retirement accounts. Moreover, with the growing availability of IRA- and 401(k)-focused nonrecourse lenders, people are leveraging their retirement accounts into properties worth three to four times what their cash-only investments would allow.

Here’s an example. A “SuccessFull Self-Director®” named Tex Free intends to purchase a $500,000 triplex in suburban Tacoma with his IRA. Tex has $200,000 cash held in a fully self-directed account administered by Entrust Northwest, LLC. He can go to the bank and obtain a $300,000 loan to pay the balance of the purchase price, but the loan must be nonrecourse. In other words, the lender cannot reach IRA assets, other than the triplex pledged as collateral, in the event of a default on the loan. In our case, the bank is willing to make the loan because there will be 40% down ($200,000 on a $500,000 purchase) and the loan-to-value (LTV) ratio is only 60% ($300,000 on a $500,000 purchase). Because of the substantial down payment and low LTV, the rental income will more than cover the monthly installments due on the loan (including taxes and insurance). So, it seems like everything is a go, right?

Tex wisely consults his tax advisor before obligating himself to the triplex transaction. The advisor reviews the deal and raises the red flag of UBIT (Unrelated Business Income Tax) and UBIT’s pernicious cousin, DFTI (Debt Financed Taxable Income). She explains that because the IRA is using the bank’s money to leverage into the triplex (together with the IRA cash), 60% of the net profits or gains realized by the IRA are subject to UBIT and DFTI. In general, the tax applies to the portion of the net income realized by the IRA in a given year determined by the following ratio: the average outstanding loan amount for the past 12 months, relative to the original acquisition cost of the property.
If the IRA sold the triplex during the first year and realized a $100,000 gain, 60% of that amount, or $60,000, would be taxable. Because the triplex was sold less than one year since its acquisition, short-term capital gains rates apply, so the tax bill would be approximately $21,000 (35% x $60,000=$21,000). The IRA would pay the tax out of the profits realized, leaving a net return of $79,000. This would result in a 39.5% cash-on-cash return in less than a year (even factoring in the tax hit).
    Had Tex partnered his IRA with another investor who contributed $300,000 cash alongside the IRAs $200,000, his IRA would hold only a 40% stake in the deal and realize only 40% of the profits ($40,000). True, there would be no UBIT or DFTI, but only $40,000 of the $100,000 profit would come back to Tex’s IRA. That boils down to a 20% cash-on-cash return, about half of what the IRA would otherwise realize by keeping 100% of the deal and leveraging the IRA through a nonrecourse loan.
    If Tex’s tax advisor were familiar with 1031 tax-deferred exchanges, she could help structure the triplex transaction to be 100% tax-deferred, even with 60% debt financing. By combining the advantages of a 1031 exchange with a Real Estate IRA, you can transcend the UBIT and DFTI problem. Here’s how.
    In the above example, Tex got clipped with the tax hit when he sold the IRA’s debt-financed triplex for $600,000 (realizing a $100,000 capital gain). However, had Tex’s IRA “exchanged” the triplex for a like-kind replacement property, meeting the 1031 exchange rules, the IRA would defer paying UBIT and DFTI on the gain. To accomplish this, Tex’s IRA would retain a Qualified Intermediary, properly convert the “sale” into a 1031 exchange, buy suitable replacement real property of an equal or greater value ($600,000 or above), take on an equal or greater amount of debt against the replacement property ($300,000 or more) and put down the net equity toward the purchase price of the replacement property (approximately $300,000, less closing costs). Like any 1031 exchange, Tex has 45 days from closing to identify potential replacement properties and 180 days to purchase one or more of the targeted properties.
    Under this approach, Tex keeps the entire $100,000 gain working for him on the next deal, rather than forking over $21,000 in taxes to Uncle Sam. His IRA could buy a fourplex worth $600,000, using $300,000 cash and a $300,000 nonrecourse loan. Here’s the beauty: because it’s now only a 50% LTV, Tex lowered the percentage of capital gains that would be subject to UBIT and DFTI from 60% to 50% ($300,000 loan = 50% of the $600,000 acquisition cost). So, if Tex’s IRA made another $100,000 when it subsequently sold the fourplex for $700,000, the DFTI tax bill would be calculated on 50% of the gain, including the deferred gain. Tex’s IRA would be well served to hold the fourplex for more than one year to take advantage of the current long-term capital gains rate of approximately 15%. Under this scenario, the tax hit would be approximately $15,000 (50% of $200,000 gain = $100,000; 15% of $100,000 = $15,000). This results in a 92.5% cash-on-cash return spread out over however many years Tex’s IRA held the real estate investments ($185k/$200k = 92.5%).
    Of course, Tex’s IRA could exchange again rather than “sell” the fourplex and continue to defer paying tax on the debt-financed portion of the gains. One of the built-in benefits of this approach is that the portion of the gains subject to UBIT and DFTI is reduced as the outstanding principal balance of the debt-financing is amortized. That’s because the rule states that the percentage of gains subject to the tax is pegged to the average outstanding loan amount over the last 12 months relative to the acquisition cost of the property financed.
    So, let’s say Tex’s IRA next buys an eight-unit building in Spokane for $750,000 with $400,000 down and $350,000 debt and then holds the building for 10 years. Tex’s IRA has a surplus cash flow during the 10-year hold, which is used to prepay the loan’s principal balance in part. In 2020, when Tex’s IRA sells the building for $1,000,000, the outstanding loan amount has been reduced to $150,000. Therefore, only 20% of the gains would be subject to UBIT and DFTI at the current rate of approximately 15%. The gains would equal $450,000, 20% of which equals $90,000. Hence, $90,000 would be subject to the 15% tax, resulting in a $13,500 tax bill. Should the debt be fully retired for more than one year before the IRA sells the eight-unit building, no UBIT or DFTI applies, so all gains come back into the IRA without tax! Under this strategic approach, our “SuccessFull Self-Director®” really lives up to his namesake: Tex Free!!

© 2009 Mark E. Hodges, Esq.
All rights reserved

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