Investing in a self-directed IRA has many advantages, including the valuable combination of two key benefits:
1. Tax deferral on investment earnings
2. Broad array of alternative investment options
Alternative investments such as real estate and limited liability companies can provide diversification and growth potential for an investment portfolio. Using a tax-deferred vehicle like an IRA to invest in these types of investments has the added advantage of deferred income on earnings. Further, if a Roth self-directed IRA is used and withdrawals are qualified, the investment growth is completely tax-free.
Sound too good to be true? There is a catch for certain types of alternative investments in an IRA. Congress realized that the tax advantages available within an IRA could give an IRA-owned business a competitive advantage over a business that is not owned by an IRA and that is paying taxes on its business income. Therefore, under IRA tax laws, an additional tax applies to “unrelated business taxable income” within an IRA (as well as certain other tax-exempt organizations).
Unrelated Business Taxable Income (UBTI)
The IRA tax rules are designed to encourage and help individuals to save for retirement. If an IRA is receiving certain income from a trade or business that is not substantially related to the IRA’s tax-exempt purpose (saving for retirement), the income will be deemed “unrelated business taxable income.” Income produced from selling goods or performing services with the intent to profit in an ongoing trade or business that is unrelated to the purpose of an IRA is considered UBTI and is subject to taxation in the year it is earned. The IRS provides guidelines and examples to help illustrate for taxpayers what is and is not taxable as business income within an IRA (See IRS Publication 598).
Income Typically Excluded from UBTI
• Rents (if not debt-financed – see UDFI below)
• Capital gains from the sale of assets
If an IRA-owned trade or business has $1,000 or more of UBTI in a year, the income is taxed in the year it is earned (rather than tax-deferred until distribution). UBTI is taxed at the tax rates applicable to trusts, which are generally higher than individual tax rates.
Unrelated Debt-Financed Income (UDFI)
Investment income that would otherwise be excluded from UBTI (such as rents) must be included in taxable income to the extent it is derived from debt-financed property. In general, the term “debt-financed property” means any property held to produce income for which there is an acquisition indebtedness at any time during the tax year. This includes rental real estate, tangible personal property, and corporate stock.
For debt-financed property, the unrelated debt-financed income (UDFI) is the portion of the income or gain that is debt-financed (i.e., the income is taxable in proportion to the debt on the property). This is generally determined based on the highest amount of debt carried within the year. As the IRA makes payments on the debt (such as a non-recourse loan for real estate), the percentage of profits that are subject to tax decreases as well. If the IRA sells the property and there is any debt during the preceding 12-months, a percentage of the gain will be considered UDFI. If the investment is held longer than 12 months after the loan is paid off, the gain is not subject to tax. UDFI over $1,000 each year is taxed at the higher trust tax rates.
UBTI/UDFI tax must be paid each year from the IRA holding the investment. The IRA owner cannot pay the tax from other assets. The tax is reported to the IRS on Form 990-T, Exempt Organization Business Income Tax Return, on behalf of the IRA by the filing deadline each year (typically April 15). Typically, the IRA custodian files the return on behalf of the IRA.
Identifying and calculating UBTI/UDFI is challenging. There are multiple exceptions, exclusions, and deductions to understand and incorporate accurately. You should seek professional tax advice if you are investing in an alternative investment that might generate UBTI or UDFI.
If you have questions about UBTI, UDFI, or alternative investment options, please contact us at Service@StrataTrust.com.