Question: I am considering investing in a 506c investment on a multifamily property. They are raising a 1 million from investors, then getting a loan and making improvements to the property and repositioning it over 5-7 years.
I wanted to use my funds from my SEP IRA which is currently in a qualified intermediary trust. What is the UBIT tax? Will I be subject to that on this deal? Also, should I set up an LLC that then loans the money to their LLC? How can I structure this for tax and liability benefits?
Answer [Note: From my CPA and not this is NOT legal or professional advice – in other words do your own research]: When you invest in a business (syndicate = business) with your IRA, the IRA will be subject to UBIT (unrelated business income tax) and UDFI (unrelated debt-financed income).
For our purposes, UDFI is produced when an IRA uses debt to purchase real estate. Essentially, the portion of the property’s income considered UDFI is based on the percentage of rental income derived from debt.
For example, Property A is purchased for $100,000. You put down 25% of the purchase price as a down payment and finance the remaining 75% with a traditional mortgage from the bank. The property produces $10,000 in net income for the year. $7,500 (75%) of the net income is considered UDFI and is subject to UBIT.
There is a deduction for the first $1,000 of income subject to UBIT. Income subject to UBIT over $1,000 is taxed at trust rates. For 2017, trust tax rates start at 15% and max out at 39.6% after just $12,400 of income subject to UBIT.
UBIT is paid by the IRA account. If for whatever reason UBIT is paid directly by the taxpayer, the amount paid is considered a contribution to the IRA.
Follow up question: Is there any difference in how the UDFI will apply for these:
1) SD IRA
3) Solo 401K
4) SD IRA (operated as an LLC) so this one is confusing… My LLC owns an LLC (syndication) which owns a property
I’m trying to decide if one is better than another for tax purposes.
Answer: The solo 401(k) is not subject to UDFI but it subject to UBIT. The IRAs are all subject to UBIT and UDFI. Note that generally the passive income flowing back to you is very low and the as a result we don’t see a huge UBIT tax.
Another idea would be to take a debt position (lending) rather than equity. The interest you would receive is free of UBIT and UDFI tax.
(This suggestion of a “debt” position or note investment with the SEP IRA to avoid UBIT and UDFI tax is a creative one… but it’s a very low chance of happening because it’s just too complicated and honestly not worth the effort from the syndicators side. It’s a very similar case of to a Tenant-In-Common (TIC) arrangement where an investor has 1031 exchange funds and wants to parlay that money into a syndication. It’s possible but from the syndicator’s perspective a lot of unneeded work when you can just raise the funds the traditional way. Caveat: if you are bringing in a huge amount of money say 50% of the raise then that might tip the scales in your favor)
Ask you can tell this is a really grey area. One CPA mentioned, the answer depends on how you structured the syndication, UBIT may or may not apply for the real estate holding for solo 401k. I would really try to toss the Operation Agreement to your individual CPAs to examine and determine ahead of time.