One of the benefits of saving for retirement in a self-directed IRA is the deferral of tax on investment growth until distributed from the IRA. Some investment options, like a Roth IRA, have tax-free investment growth—if you wait to distribute those earnings until you have reached age 59½ and have had a Roth IRA for at least five years. But when self-directed IRA assets are invested in certain types of income-generating investments, the IRA itself is required to pay tax each year on the investment income. This payment of tax does not create basis in the IRA. Instead, think of it more like the cost of doing business within a tax-exempt entity, such as an IRA or other qualified retirement account. There are two types of investment income taxes to be aware of as the tax deadline approaches.
Unrelated Business Taxable Income (UBTI)
The type of investment income that is subject to current-year taxation is referred to as Unrelated Business Taxable Income (UBTI). It’s called “unrelated” income and it’s taxable because the IRS views the ability to generate certain types of taxable income within a tax-exempt entity (like an IRA) as an unfair advantage over businesses that are paying tax on their income. UBTI is generally defined as income earned from selling goods or performing services with the intent to profit in an ongoing trade or business that is not related to the exempt purpose of the IRA, which is to provide retirement income to the IRA owner. If your IRA investments generate $1,000 or more of UBTI in a year, the IRA must pay tax on that income. Because the income is earned within a trust, UBTI is taxed at the trust tax rates.
Certain types of income are generally not considered UBTI though, including interest, dividends, royalties, capital gains from the sale of assets, and rents (if not debt financed). Identifying and calculating UBTI is complex. Multiple exceptions, exclusions, and deductions apply. Seek professional tax advice to assist you with determining if your investment or prospective investment would generate UBTI.
Unrelated Debt-Financed Income (UDFI)
Like UBTI, Unrelated Debt-Financed Income (UDFI) is taxable income to the IRA. If an IRA is invested in property that has been purchased with a non-recourse loan or is invested in a Limited Liability Partnership (LLP) or Company (LLC) that has obtained debt-financing to purchase property, income generated by that property is also viewed by the IRS as having an unintended tax advantage.
The amount of income classified as UDFI is proportionate to the debt owed on the property. As the debt is paid down, the percentage of income that is taxable decreases. If the IRA sells the property and there is any debt during the preceding 12-months, a percentage of the gain will be taxable as UDFI.
As a self-directed investor, you are responsible for determining if your IRA investments have generated UBTI or UDFI of at least $1,000. If so, you are required to complete IRS Form 990-T, Exempt Organization Business Income Tax Return, to report this income. Each investment should be reported on a separate Schedule A.
For 2021, Form 990-T must be filed electronically with the IRS, and the tax paid, by April 18, 2022 (an extension to file may be requested). Payments to the IRS must be made from your IRA account. Please ensure you submit the completed documentation required by early April to your IRS custodian for this process.
Tips For Filing IRS Form 990-T
Your service providers should be able to assist you with these tasks:
• Your investment sponsor may provide you with information regarding UBTI/UDFI. For example, if the IRA is invested in an LLP or LLC, the IRA will receive a Schedule K-1 (Form 1065) to report income for the year. Part III, Box 20, will report if there is any UBTI using code V.
• Your tax professional may assist you with calculating UBTI/UDFI, securing an Employer Identification Number (EIN) for the IRA, and completing and/or filing Form 990-T.
• Your IRA custodian will pay the tax from your IRA with your authorization.
If Form 990-T is filed late or not filed, the IRS may assess penalties and interest. The minimum penalty for a return that is more than 60 days late is the smaller of the tax due or $435.
STRATA Account Holders
For STRATA account holders, send a copy of your completed Form 990-T and Form 8879-EO to STRATA, along with STRATA’s Expense Payment Authorization form, authorizing STRATA to make the payment directly from your IRA to the IRS.
Selecting the ServiceNOW option allows you to securely, electronically upload your documents and submit your expense request in just a matter of minutes.
Remember to allow sufficient processing time for STRATA to receive the documents and submit payment to the IRS by the April 18, 2020 filing deadline.
For more information, visit our FAQ section on UBTI or read more about Tax on Unrelated Business Income of Exempt Organizations in IRS Publication 598.
You can find details about Schedule K-1 and Form 990-T on the IRS official website.
Download STRATA’s Quick Guide to UBTI/UDFI for a better understanding of taxable event triggers and tax reporting, and additional information about IRS Form 990-T.