Borrowing Money Creates Tax
Annie Investor has $500 in her Roth IRA. She can borrow
$80,000 for a fix-n-flip from a Private lender at 10% per
year.. Her $80,500 purchases and rehabs a property that she
sells for $110,000 in four months. Annie must pay her lender back
Her sale $110,000 (net of all costs) less the loan of $82,666.67
leaves her $27,333.33! That's a pretty nice profit starting
with just $500.00.
Unfortunately, that's not her profit. She owes tax, and she
owes a lot of it.
The main disadvantage of IRAs, both Roth and Traditional, is the
tax that's generated when an investor uses their most powerful tool
The following explanation demonstrates the negative impact of UBIT,
and how it affects the return for the investor.
For a full explanation of UBIT, UDFI, and their effect on leveraged
transactions, get the book "Live Tax Free Forever."
UDFI and UBIT
Normal people (you and I) call it loan-to-value, the IRS calls it
UDFI. This why: The IRS wants to know "Did you have
income?" Annie had $27,333.33 in income. Next they ask
"Did you use any DEBT to generate that income?" Yes! She
borrowed $80,000. They then want you to figure out the
percentage of Debt (loan to value) used to generate that income
(UDFI). Annie divides $80,000 by $80,500, so her loan to value
(UDFI) is 99.38%. That means she must pay tax on 99.38% of her
profit! Her profit is $27,333.33. $27,333.33 x .9938 is
$27,163.86. Annie must pay tax on $27,163.86.
UBIT stands for Unrelated Business Income Tax. This is the
tax on transactions that exist in an IRA. This tax rockets to
39.6% after $12,400 of profit. Compare that to corporate
income tax. You have to earn $10 Million in your corporation
before you pay 35%. This is a pretty harsh tax! Without
going into the entire calculation, Annie must pay $9,119.60 in UBIT!
That's a third of her profit! That's a pretty big bite for a
fairly small transaction.
Eliminate UDFI and UBIT
Annie doesn't get to keep $27,333.33. She has to pay
$9,119.60 in UBIT. OUCH! That's a third of her
profit! Out of her $27,333.33, she only keeps $18,213.73.
Wouldn't it be great if Annie could keep all the money she earned?
Using a solo 401K completely ELIMINATES UDFI and UBIT in this
instance. 401Ks do not incur UDFI on transactions
financed by third parties!* Annie gets to keep her entire
$27,333.33 for doing EXACTLY THE SAME transaction in her 401K versus
FOR THE SAME TRANSACTION!
Knowing the impact on a client, why would
a financial institution recommend an IRA instead of a 401K?
Which would you want to use?
Furthermore, there is no reporting
requirement for smaller 401Ks. Annie would not have to fill
out a 5500EZ until her account reaches $250,000, eliminating filing
fees, reporting fees