In Part 1 of this series, we introduced some of the basic concepts behind investing in a multi-family real estate syndication with your IRA. Since most of these projects use debt-financing in addition to investor capital, this generates exposure to tax on Unrelated Debt-Financed Income (UDFI) for an IRA investor.
What we learned is that the impact of UDFI taxation on operating rental income from a syndicate is generally minimal. Using leverage in an investment can improve the overall performance of the project.
While an IRA is subjected to some taxation on the percentage of income derived from the borrowed capital, the tax cost represents only a small fraction of the benefits that leverage brings to the table. An IRA investor can still expect very solid returns in such projects.
In this article, we want to address how UDFI taxation impacts the exit phase of the project when the property is sold.
When UDFI Applies to a Property Sale
If mortgage debt is still in place when a property is sold, then the gain on sale is treated as debt-financed and subject to UDFI.
The UDFI calculation uses the highest acquisition indebtedness value during the 12 months prior to the sale. If a property is fully paid off a full 12 months prior to sale, there is no UDFI implication.
In most syndicated deals, the property is sold long before retiring the debt, so there’s likely going to be a taxable gain for the IRA investor.
How UDFI is Applied to Sales
All tax calculations for UDFI hinge on the debt-financing ratio.
The debt-financing ratio results from dividing acquisition indebtedness by the adjusted cost basis of the property. At the disposition of property, the highest amount of acquisition indebtedness in the 12 months prior to the sale is used.
This is a different formula than the average debt balance over the course of the year we used when dealing with operating income.
The formula for average adjusted basis is the same as that used for operating income. The beginning and ending values for adjusted costs basis during the portion of the year the property was held are averaged.
Each year, the full value of straight-line depreciation on the building is applied to reduce the beginning-of-year basis.
At the time of sale, the debt-financing ratio is determined by dividing the highest acquisition indebtedness over the last 12 months by the average adjusted basis during the period the property is held during the final tax year.
The debt-financing ratio is applied to the capital gain. Capital gains are calculated using the same logic as in a non-qualified property sale, including the recapture of depreciation.
Our Sample Multi-Family Project
Here is a refresher on the real estate deal we are using for our analysis.
- 216-unit apartment
- Purchase price of $25M
- Acquisition cost total of $26.25M with commissions, closing costs, etc.
- $10M down, consisting of $1M from the general partner and $9M from investors as limited partners
- 10-year hold, with the goal of improving performance and thereby raising both rents and occupancy rates
- Sales price after 10 years projected at $34.5M
- A $100K limited partner investor will have a 1% equity stake in this deal
Review of Rental Income
During the 10-year hold period, the projections for income would produce the following return on our hypothetical $100K IRA investment into this project.
|Cash Distributions from Partnership||$95,63.40|
|Tax on UDFI||$5,750.33|
|Net income to IRA||$89,313.07|
|Return on Investment||8.93%|
The Property Sale
Let’s assume the property sells as projected for $34.5M. That means our 1% IRA investor’s stake will represent $345K.
Sales costs of 4% are typical in these types of deals, allowing for broker commissions and transactional fees. This means a $13,800 cost of sales and a net sales price of $331,200.
The outstanding share of debt is $145,757.60.
After a return of originally invested capital, the net gain from the sale is $85,442.40.
Because there is still outstanding debt, UDFI will apply to the gain.
The actual cash gain of $85K is not used for UDFI calculations. Rather, the normal rules for determining capital gains apply. Here is how that works out using the 1% values of our IRA investor:
|C||Net Sales Price (A-B)||$331,200|
|D||Initial Cost Basis||$262,500|
|F||Adjusted Basis at Sale (D-E)||$176,805|
|G||Capital Gain (C-F)||$168,195|
|H||Highest Debt Balance in Prior 12 Months||$149,344|
|I||Average Adjusted Basis||$181,090|
|J||Debt Financing Ratio (H/I)||0.82|
|K||Gain subject to UDFI (G x J)||$138,7409|
|L||UDFI Capital Gain Tax (K x .20)||$27,742|
|M||Actual Cash Distribution||$85,442|
|N||Post-UDFI Cash to IRA (M – L)||$57,701|
Project Performance Review
This project looks to have the potential to be a good investment for the IRA. It may generate better than average returns in an investment backed by the security of real property.
Here are the top-line numbers after allowing for UDFI taxation:
|10-Year Cash Flow||$89,313|
|Gain at Sale||$57,701|
The fact that tax on UDFI will apply to the gains doesn’t diminish the overall positive results. The use of leverage in the transaction boosts the return, and your IRA certainly benefits.
When comparing this opportunity to other investments the IRA may take part in, it will be difficult to find something that is as secure and predictable, with a 14% return.
Supercharging the Opportunity
As we have seen, an IRA can expect solid returns from participation in a well-executed multi-family real estate partnership. In fact, the returns are considerably better than most folks regularly achieve with their IRA.
But what if we were to make the same investment using a Solo 401(k), with immunity to UDFI taxation?
Most anyone can establish a self-directed IRA and have the opportunity to invest in a more diversified fashion. Investors who are self-employed and have no-full time employees may be eligible for a Solo 401(k).
As a qualified employer retirement plan, a 401(k) is exempted from taxation on UDFI in specific cases per IRC Section 514(c)(9).
- Only debt-financed income produced when the debt is associated with the acquisition of real property is exempted.
- When investing in real estate indirectly via a partnership, the income and costs of the partnership must be allocated equally, meaning that depreciation cannot be shifted only to partners not using retirement funds for example.
So, what would this deal look like for an investor with a Solo 401(k)?
Here are the top-line numbers without the impact of UDFI taxation:
|10-Year Cash Flow||$95,063|
|Gain at Sale||$85,442|
An investor with a Solo 401(k) would make an extra $33,491 on this very same opportunity.
Not everyone qualifies for a Solo 401(k), and we caution about trying to force qualification, but when there is a good fit for the Solo 401(k), it’s clearly a better tool for the job.
Not many investments available to an IRA or 401(k) investor have the potential to produce 14% returns consistently over a 10-year period. Of course, there is also the real difference between the pro-forma projections of an investment sponsor and the real outcome of a project.
Like all investments, you must do your homework and diligence to create the best possible pathway to success.
The fact that an IRA investor will be subjected to tax on a debt-financed real estate partnership is neither here nor there at the end of the day. A good investment is a good investment, and the overall mix of risk and reward is what really matters.
In our experience, most investors will take a 14% return on a leveraged investment with exposure to UDFI instead of a 9% return on a non-leveraged investment.
Disclaimer: The examples provided in this article are for education purposes only and should not be construed as tax guidance. Several assumptions have been taken for simplicity of illustration such as full tax-year holdings of the property in the initial and final years. Each opportunity is unique, and many factors such as the design of a partnership can impact a participant using retirement plan funds. You should always seek qualified, licensed tax counsel when evaluating an investment using debt-financing.