As noted in a prior “Did You Know”, investing in real estate through a self-directed IRA can be a great strategy for increasing returns on that financial resource. However, IRAs, which are generally not taxed, are subject to income tax known as UBIT (unrelated business income tax) on certain types of income from real estate investments. The tax is imposed at the highest marginal rate (37%).
One way to reduce UBIT liability in a self-directed IRA is to invest through a blocker corporation. This is done by establishing a C Corporation and then investing the retirement funds into the C Corporation before the funds are ultimately invested into the planned investment. The “C Corporation Blocker” strategy will not eliminate all the UBIT tax because the business income would be subject to corporate tax, which is 21% in 2023. However, the 21% corporate tax rate is less than the 37% maximum UBIT tax rate.
UBIT may be further reduced by funding the blocker corporation in part with loans from the IRA. For example, the IRA may fund the blocker with 20% equity and then make a loan to the blocker for the remaining 80% which would then use the funds to invest in the underlying asset. The primary goal of leveraging the blocker is to take advantage of the interest deduction to reduce the amount of the blocker’s taxable income. When the blocker receives income from the investment, it will have a deduction for interest paid on the loan to the IRA to offset all or a portion of the taxable income.
Bottom Line: The use of blocker corporations funded in part with loans by self-directed IRAs can be an effective strategy for reducing or eliminating UBIT liability. Investors should carefully consider the pros and cons of this strategy and consult with a financial professional before making any investment decisions.
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