IRA Investment: Income Tax Surprise

At a glance

• Main takeaway: It’s not difficult to come by a traditional retirement plan, however, it’s not as common to find a plan trustee that allows investments in real estate, specifically debt financed property.
• Impact on your business: For some, an investment in real estate is preferred over traditional retirement plan options, such as mutual funds and the stock market, even though an investment in rental property could lead to greater risk that could generate taxable income.
• Next steps: Aprio’s Retirement Plan Services team can help you determine your tax reporting obligations from retirement investments in real estate.

Schedule a consultation with Aprio today

The full story:

It’s not difficult to find an article that promotes the use of Individual Retirement Account (IRA) funds to invest in real estate. You will not find traditional retirement plans with a traditional plan trustee or custodian allowing real estate, such as a direct investment in rental property, as an investment choice unless it is available as a publicly traded partnership or Real Estate Investment Trust (REIT).    

The traditional plan trustee does not want the potential risks associated with an investment that can generate taxable income as well as risks associated with prohibited transactions related to self-dealing.

Why take the risk when it is so much easier to limit the investment choices to a selection of mutual funds?  

Some investors prefer real estate over mutual funds and the stock market. Self-directed IRA’s can find a trustee that will allow direct investment in real estate. The scope of this article will focus on investments in partnerships which invest in real estate with debt financed property.  

Real estate with debt financed property

While some real estate investment partnerships may be organized to avoid debt when purchasing real estate, the normal real estate purchase involves a down payment and a loan from the seller or a traditional lending source, such as a bank. When a partnership incurs debt to finance an investment in real estate the property becomes “debt financed.” Income generated from a “debt financed” property will subject the IRA to income tax on the net income. There is an exemption for the first $1,000 of debt financed income or what the IRS calls unrelated business income (UBI). While rents earned on property with no debt are not UBI and can be deferred in the IRA in the same manner as dividends and interest from a mutual fund, if the income is UBI as a direct result of debt financing, a portion of the net income is subject to income tax.

There is a formula that only the real estate partnership will be able to calculate to determine what percentage of the net income is UBI. The formula looks at:

The ratio of average debt to average adjusted basis is applied to the total net income from the rental property to determine the amount of UBI for the partnership as a whole. This total will be allocated to the individual partners in respect to their profit and loss percentage of the partnership.  

How can the individual partner know what this amount is?  

A retirement plan investment in a partnership will receive Form K-1 with the partner’s distributive share of income and deductions each year. It’s important to review the notes that are part of the Form K-1 information. You may see a note similar to the following:

Statement regarding unrelated business taxable income for the tax-exempt members pursuant to IRC Section 6031 (D):

The percentage of Box 2: Rental Real Estate Income from Debt-Financed Property is determined below:

Average Acquisition Indebtedness		$XXXXX
Average Adjusted Basis		$XXXXX

The bottom line

While there is an exemption of $1,000 of UBI before income tax will apply, this is a cumulative annual total and not a per investment total. Aprio’s Retirement Plan Services team can help you determine your tax obligations and answer questions about UBI from your retirement.

Schedule a consultation with Aprio’s Retirement Plan Services team today.