UBTI: Understanding Possible Tax Triggers on an IRA’s Income
It is well known that one advantage of a self-directed IRA is that it may allow you to grow your investments tax-deferred if you are using a traditional IRA or tax-free with a Roth IRA. The investment income generated by most passive investments held in your IRA — like dividends from equities or gains on the sale in real estate — are deferred until you withdraw funds from the IRA, or tax-exempt on the gains with a Roth IRA.
What isn’t as well known is that some investments in an IRA have the potential to produce taxable income. This is known as Unrelated Business Taxable Income (UBTI), and it is a topic that is often misunderstood among many self-directed IRA investors and their advisors. (UBTI is also referred to as Unrelated Business Income Tax or UBIT).
The Q&A below helps explain UBTI/UBIT. We address not only what UBTI is but also why it causes such confusion, and how income tax can be generated in your self-directed IRA.
Question: Why does so much confusion exist around UBTI?
When we think of taxes related to IRAs, we tend to the think about the opportunity to decrease our taxable income or we associate taxes with withdrawals—but we don't think about the possible tax impacts during the life of the IRA investment.
Q: What are some examples of investment income that is exempt from UBTI?
A: There are a number of investment income types that can be generated in a self-directed IRA and are exempt, including:
1. Rent generated from real estate holdings
2. Interest made from lending money
3. Capital gains from the sale or disposition of assets
4. Dividend income from a C-corp where the company paid corporate tax
5. Royalty income derived from intangible property rights such as intellectual property, or oil/gas and mineral leasing activities
Q: When does UBTI apply?
A: Think of UBTI as a tax that is due to an IRA when it receives “business income” as opposed to “investment income” (not leveraged with debt).
Two common events tend to trigger UBTI. The first occurs when an IRA buys LLC ownership in an operating business – a business that sells goods or services – that is structured as a pass-thru entity for taxes that does not pay corporate taxes.
In this case, income from the LLC flows to its owners and would be considered ordinary income. If the company has net taxable income, it will flow to the IRA as ordinary income on a K-1 tax form. This will cause the IRA to pay tax because the income is considered business income that does not fit one of the investment income exemptions.
Another area is when the IRA engages in real estate investments that do not result in investment income. For example, buying and selling a significant number of short-term real estate flips by an IRA will cause the assets of the retirement account to be considered as inventory vs. investment assets. This will result in taxable income.
Q: Why do real estate investors, in particular, need to be aware of another way UBTI can be triggered?
A: UBTI also applies to an IRA when it leverages its purchasing power with debt. This is the most common trigger for UBTI among PENSCO clients. For example, if an IRA uses debt to buy an investment, like a single-family rental property, the income attributable to that debt is subject to UBTI. This income is referred to as unrelated debt financed income (UDFI), and it causes UBTI.
This most commonly occurs when an IRA buys real estate with a non-recourse loan. For example, let’s say an IRA buys a rental property for $100,000. Now let’s say $40,000 came from the IRA and $60,000 came from a non-recourse loan. The property is 60% leveraged, meaning 60% of the income is a result of the invested debt. Because the debt is not retirement plan money, the IRS requires tax to be paid on 60% of the income. If there is $10,000 of rental income on the property, then $6,000 would be UDFI. UDFI is calculated proportionate to the average loan balance for the year and the average cost basis for the year.
A relatively recent change to UBTI resulted from the Tax Act and JOBS Act of 2017. In the past, clients could possibly offset UBTI from one entity with losses from another entity and aggregate gains and losses together to potentially lessen the impact of UBTI. With the passage of the Act, that can no longer happen. UBTI must be calculated for each entity and cannot be aggregated with any other entities. For example, if one entity generates UBTI of $10,000 that amount has to stand alone and cannot be offset with losses from another entity.
Also, prior to the Act, Net Operating Losses (NOL) could be carried back but this has been eliminated. However, NOL can still be carried forward.
(Stay tuned for updates to the IRS 990-T which is expected to reflect that tiered trust tax rates have been eliminated.)
Q: How does an IRA owner pay UBTI?
A: Unrelated business taxable income for an IRA is reported and paid via IRS Form 990-T, which is due on April 15th. This return is separate from the IRA owner’s personal return. IRA owners can file and obtain an automatic 3-month extension with the IRS by filing an extension request before the regular deadline. Keep in mind the extension only applies to filing, not paying.
If UBTI tax is due, it is paid from the IRA. Typically, the IRA owner sends the prepared Form 990-T to their IRA custodian to obtain their signature and direct payment to the IRS for any tax due. To see the tax rates for UBTI, you can view the IRS Publication 598 and the instructions for Form 990-T (see instructions for Line 40 and the trust tax rates table below that on page 20 of the instructions for Form 990-T).
This Blog does not provide investment, tax, or legal advice nor does it evaluate, recommend or endorse any advisory firm or investment vehicle. Investments are not FDIC insured and are subject to risk, including the loss of principal.
PENSCO Trust Company performs the duties of an independent custodian of assets for self-directed individual and business retirement accounts and does not provide investment advice, sell investments or offer any tax or legal advice. Clients or potential clients are advised to perform their own due diligence in choosing any investment opportunity as well as selecting any professional to assist them with an investment opportunity. Alternative investments are not FDIC insured and are subject to risk, including loss of principal. PENSCO is indirectly affiliated with a registered broker dealer and with a licensed small business investment company through Opus Bank (“Opus Affiliates”). Other than the Opus Affiliates, PENSCO is not affiliated with any financial professional, investment, investment sponsor, or investment, tax or legal advisor.
 Taxes and tax penalty may apply if the distribution from your Roth IRA is not a qualified distribution. You should consult with your tax professional to determine any applicable penalties or taxes.
 property must be owned debt free by IRA
 property must be owned debt free by IRA