Case Study: Financed Purchase
The following case study depicts how one of Advanta IRA’s clients was able to invest in a rental property without having the full purchase price to invest.
Rachel wants to invest in a $100,000 rental property, but she only has about half of that amount in her IRA to make the investment. She decides that her IRA can make a 40 percent down payment on the rental property and obtain a non-recourse loan for the remaining 60 percent of the purchase price.
Since Rachel used financing to purchase the real estate in her IRA, income received by the IRA is subject to Unrelated Debt Financing Income (UDFI) tax. (Although they are different, this is often referred to as UBIT. For any rental income that her IRA receives, 40 percent of that income reverts to her IRA with no tax consequence. The other 60 percent of income is subject to UDFI. For example, if her IRA receives $1,000/month in rent, $600 of that income is subject to UDFI.
On the flip side, when an IRA is subject to UDFI tax, the IRA can take certain deductions to limit the impact of the UDFI tax. Her IRA can offset part of this tax by deducting 60 percent of certain expenses (property taxes, mortgage interest, repairs, etc.) and depreciation from the total income. Rachel’s IRA only pays tax on the net income.
Rachel’s IRA pays the mortgage each year and the property value increases. Therefore, the ratio of her IRA’s debt to equity decreases, meaning the percentage of the income subject to UDFI decreases as well. If Rachel decides to sell the property, her IRA receives the proceeds from the sale and owes UDFI tax on a portion of the profits. If the non-recourse loan is paid off by the time she sells, no UDFI applies!