The real estate market in many parts of the country continues to be very strong. This is encouraging many individuals to consider it as an alternative to the stock market. Those thinking of using an individual retirement account (IRA) to make investments in real estate must understand the potential tax implications when making those decisions.
IRAs are not subject to income tax on most investment income such as interest, dividends, and capital gains. They may, however, have income tax liabilities if their investments generate unrelated business taxable income (UBTI). This article presents an overview of UBTI and delivers example calculations and best practices to assist in quantifying the potential impact of UBTI on commercial real estate investments.
Investments in real property assets can generate income in a variety of ways so it is important to understand what income is subject to unrelated business income tax. The good news for investors is that rental income often is excluded from UBTI. In order to be excluded, rental income of real property must meet the following criteria:
Based on the above it is fair to say that not all rents are equal when considering investments in different real property asset classes. It would be uncommon for office, industrial, multi-family, medical office, student housing, and retail to fail any of the above tests, and these rents should qualify for the exclusion from UBTI.
The hospitality asset class is one exception that will create UBTI as a rule. Also, investments in real property developments (ex: ground-up developments) will often create UBTI unless they are held as rental properties after completion. It is always advised to ask the general partner or LLC manager if the asset class will create any UBTI, as well as consult with your own tax professional, prior investing.
Meeting the above tests for rental income exclusion does not automatically close the book on the generation of UBTI, unfortunately. Excluded rents will still be subject to unrelated business income tax if the properties are debt-financed, which constitutes debt-financed income (DFI).
To determine the amount of DFI in a year for any property, the debt-financed ratio must be calculated. This ratio is computed by the average of the beginning and ending principal balance of the debt for the year, over the average of the beginning and ending basis of the property after additions, disposals and depreciation are factored in. The debt-financed ratio is multiplied by the gross rents and the property expenses for determining net UBTI for the property.
Example 1: A tax-exempt investor acquires a 20% interest in an LLC that purchases an office building on January 1, 2017 for $10M in an all-cash transaction. The property generates $750K of gross rents, $310K of operating expenses, and $200K in depreciation expense. The tax-exempt investor’s 20% allocable share of the LLC’s $240K of net rental real estate income is $48K and not subject to unrelated business income tax.
Example 2: Same as Example 1, except the LLC finances $3.3M of the purchase with an interest-only loan. The net income on the property after $150K of interest expense is now $90K. The tax-exempt investor’s 20% allocable shares of the gross rents and expenses are $150K and $132K, respectively, for net rental real estate income of $18K. The DFI calculation is:
$3.3M avg acquisition indebtedness/$9.9M average adjusted basis = 33.3%
33.3% x $750K gross rents x 20% share = $50K income subject to unrelated business income tax
33.3% x $660K gross expenses x 20% share = $44K deductions against UBTI
$6K net UBTI
The DFI calculation must be done for each year there is acquisition indebtedness on the property at the beginning of the taxable year. Note that DFI will include gain on sale if there was debt on the property in the year of sale, which could result in significant tax due on the UBTI.
Partnerships are required to provide each partner with their allocable share of partnership income, gain, losses, and deductions for the taxable year on Schedule K-1. Any UBTI allocable to the partner for the year is reported in Box 20, Code V.
The lack of UBTI reported on Schedule K-1 does not guarantee that the partnership did not generate unrelated business income tax. While it is best practice for the general partner or LLC manager to obtain a Form W-9 from each partner to verify their tax status, it is the partner’s responsibility to inform the partnership of its tax-exempt status. This can be especially important in tiered partnerships where tax-exempt investors are not invested directly in the partnership that holds the property but hold their interest in a lower-tier partnership.
A tax-exempt partner receiving a Schedule K-1 with UBTI must now determine whether there is a filing requirement to report the income. A filing requirement exists only if the allocable gross receipts subject to unrelated business income tax exceed $1,000. Note that this information is not reported in Box 20, Code V, so the partner may need to request additional information from the partnership. Ideally, this information is provided in a footnote or schedule accompanying the Schedule K-1 so that each tax-exempt investor has the full information needed to make this determination.
UBTI is reported by filing Form 990-T, which is due by May 15th for calendar year tax-exempt partners. The extended due date for this return is November 15th. The income is taxed at trust tax brackets, for which the highest tax rate reached 39.6% on $12K of taxable income. This income is also subject to the 3.8% net investment income tax rate. Gain on the sale of property is eligible for capital gains rates of 20% if the one-year holding period has been attained.
Example 3: Continuing from Example 2 above, the investor has a filing requirement due to the $50K of gross income subject to unrelated business income tax. The $6K of UBTI is taxed as ordinary income resulting in $1,245 of federal tax due.
Example 4: Continuing from Example 2, the LLC sells the building on January 2, 2018 for $12.8M. The gain on sale for the LLC is $3M ($12.8M sales proceeds less $9.8M adjusted basis), of which the tax-exempt investor’s 20% allocable shares of the gain and gross proceeds are $600K and $2.56M, respectively.
$1.65M avg acquisition indebtedness/$4.9M average adjusted basis = 33.6%
33.6% x $12.8M sales proceeds x 20% share = $860K income subject to unrelated business income tax
33.6% x $3M Sec. 1231 gain x 20% share = $201K net UBTI
Since Sec. 1231 gain is taxed at capital gain rates, the $201K of UBTI is taxed at 23.8% (20% capital gains + 3.8% net investment income tax) for a federal liability of $48K.
Tax liabilities necessitate liquid assets for the tax-exempt investor to make these payments. Therefore, advance planning is needed to ensure that partnership distributions are not reinvested in illiquid assets leaving the investor no wherewithal to pay the tax bill.
The filing requirement if gross receipts are in excess of $1,000 also applies if the partnership generates UBTI loss for the year. It is valuable to report this loss, which can be carried forward and applied to future UBTI to reduce the tax liability.
Finally, don’t forget to also determine if there are state tax filing requirements on the UBTI. For investments in real property, nexus is created by the location of the property that generates UBTI. For example, a tax-exempt partner residing in Washington (a state that does not have income tax) may be subject to tax in California if the rental property is located there.
It is beyond the scope of this article to discuss the impact of the Tax Cuts and Jobs Act on real estate taxation, but it is safe to say there are some taxpayer-favorable provisions to depreciation of real property improvements that may decrease UBTI in the coming years. In addition, since UBTI is taxed at trust rates, the top rate will be reduced to 37% starting in 2018.
Finally, a change specific to tax-exempt investors is the disallowance of UBTI losses against UBTI income in another activity. Prior to 2018, all UBTI activity was aggregated for tax-exempt entities in determining tax liability.
Before investing in a real estate investment with your IRA, investors should ask the general partner or LLC manager the following questions:
Finally, It is important to note that UBTI and the resulting taxes are not a penalty, but they do constitute an additional cost of the investment. By asking the right questions investors will have a better grasp on all the costs of the investment, which will allow them to make the determination if the investment should be held individually or through an IRA.