Making investments with funds from a self-directed IRA provides a great tax advantage in that most income is tax-free until distribution. However, there are certain situations in which a self-directed IRA can generate taxable income in the form of unrelated business taxable income (UBTI) or unrelated debt-financed income (UDFI). UBTI is one of the more complicated areas of tax law, but the basic guidelines are fairly straightforward when it comes to UBTI generated by an investment held within an IRA.
According to IRS Publication 598, UBTI is “gross income derived by an organization from any unrelated trade or business regularly carried on by the exempt organization, less the deductions directly connected with carrying on the trade or business.” UBTI, or unrelated business taxable income, is the tax that is paid on UBTI generated from a trade or business.
Publication 598 also states: “If an exempt organization regularly carries on a trade or business not substantially related to its exempt purpose, except that it provides funds to carry out that purpose, the organization is subject to tax on its income from that unrelated trade or business.”
There are exceptions, and most income generated by passive investments is exempt from paying UBTI, including income from dividends, annuities, royalties, interest from loans and most rent generated from real estate.
Investments Generating UBTI
Investments most likely to generate UBTI include limited liability companies, limited partnerships, leveraged properties and investments in active businesses. In order for income to be subject to tax as UBTI the following must be true:
• The income is generated by a trade or business.
• The trade or business activity is regularly carried on.
• The trade or business activity is not substantially related to the exempt status.
UBTI Tax Filing
At the end of the tax year, investment sponsors will prepare and send out Schedule K-1. UBTI for the investment is shown under Section 20, Other Information. The amount of UBTI generated for the tax year is listed as Code V. If this figure exceeds $1,000, IRS Form 990-T would need to be filed to report and pay any UBTI due. Those required to complete Form 990-T will need to file for an Employer Identification Number (EIN) and can do so using Form SS-4.
If your IRA does owe UBTI, it is best to consult a tax professional. A tax professional will ensure the registration and Tax Identification Number on the Schedule K-1 are correct and prepare Form 990-T to submit to your IRA custodian. Once completed, you can then provide the Form 990-T to your IRA custodian with your authorization to file the form and pay the UBTI from your IRA account.
If you are considering an investment that may generate UBTI, your tax advisor should be consulted in advance. To learn more about unrelated business taxable income please view IRS Publication 598.