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A self-directed Individual retirement account (IRA) is an investment account that allows individuals to choose their own investment options, including real estate. However, income earned through certain types of investments may be subject to Unrelated Business Income Tax (UBIT).

UBIT is a tax on income unrelated to the primary purpose of the tax-exempt organization or retirement account. In the case of self-directed IRAs, UBIT may apply to income earned from investments that are considered unrelated trades or businesses.

Real estate investments made through a self-directed IRA may be subject to UBIT if the property is financed with debt or if the property generates rental income. Rental income is considered unrelated business income, while debt-financed property is subject to a percentage of UBIT called Debt-financed Income Tax (DFIT).

To avoid UBIT or DFIT, individuals can make real estate investments using non-recourse financing. Non-recourse financing does not use the assets of the IRA as collateral and therefore does not trigger UBIT or DFIT. Non-recourse financing typically requires a higher down payment and may have higher interest rates, but it allows for tax-free earnings on the investment.

Another way to avoid UBIT or DFIT is to invest in properties that do not generate rental income, such as vacant land, or to own property through a Limited Liability Company (LLC) owned by the IRA. The rental income generated by the LLC will not be subject to UBIT, but the LLC may be subject to taxation on its profits.

It’s important to note that UBIT is only triggered by income generated by the investment and does not affect the overall value of the investment. Additionally, UBIT is only applicable to investments made through a self-directed IRA, not traditional IRAs or 401(k)s.

Investing in real estate using a self-directed IRA can be a powerful tool for retirement planning, but it’s important to understand the potential tax implications. Speaking with a financial advisor who specializes in self-directed IRAs can help individuals navigate the complexities of UBIT and DFIT and make informed investment decisions.