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Understanding Unrelated Business Taxable Income and your IRA

  |  By Chris Shanahan, CISP®

One of the perks of a self-directed IRA is that it allows you to grow your investment tax deferred in the case of a traditional IRA or tax free in the case of a Roth. The investment income generated by most passive investments held in your IRA — like dividends or gains on the sale of real estate or interest on loans — are exempt from taxes.

But with Tax Day approaching it’s important to understand how an investment in your self-directed IRA could produce Unrelated Business Taxable Income (UBTI) or Unrelated Debt-Financed Income (UDFI) and be subject to taxes.

The Purpose of UBTI

What is Unrelated Business Taxable Income (UBTI)?

UBTI is a unique tax that was created by Congress in 1950, and it applies to tax-exempt entities such as charities, churches and universities. Congress was concerned about exempt organizations running unrelated businesses without paying taxes on the income produced by those businesses.

The purpose of UBTI is to level the playing field and prevent tax-exempt entities from competing unfairly with taxable entities, like corporations. The IRS states that unrelated business income is income generated from an ongoing trade or business that is not related to the organization's exemption.

The reason UBTI is an issue for retirement investors is because all IRAs -- Traditional IRAs and Roth IRAs -- are considered by the IRS to be a tax-exempt or tax-deferred entity for the purpose of saving for retirement. That means if an IRA produces income from an “unrelated business,” that income could be taxable.

A Christmas Tree Farm and UBTI

IRS Publication 598 covers the rules for UBTI, but UBTI can be a bit complicated so let’s use the example of an investor who owns a piece of land in their IRA through a single member LLC. It’s a passive investment producing no UBTI income, so it’s not subject to UBTI taxes. Then the IRA pays to make improvements to the land and turns the property into a Christmas tree farm. Suddenly, the investment is no longer passive, and it begins to produce an income stream selling Christmas trees.

The improvement of the land and the sale of these trees mean the IRA could be subject to UBTI. If your IRA owns an operating company – like a Christmas tree farm -- the income it produces from selling goods and services – like Christmas trees -- would be subject to UBTI because the operating company itself is unrelated to the central purpose of an IRA, which is to save for retirement. 

According to Jim Blankenship of the blog Getting Your Financial Ducks in a Row the best way to determine if income is “unrelated” is to ask these two questions:

  1. Is the income from a trade or business that is regularly carried on?
  2. Is the trade or business unrelated to the tax-exempt entity’s exercise of the entity’s tax-exempt purpose?

If these two tests are met, Blankenship says, then the income may be subject to UBTI.

Understanding UDFI

There is a sub-set of UBTI that self-directed IRA investors should also understand – Unrelated Debt-Financed Income, or UDFI. If a property purchased by an IRA is debt-financed, income produced by that property could be considered UDFI and the income could be subject to taxes.

As an example, UDFI can be triggered if your IRA owns a rental property. Let’s say your IRA takes out a mortgage to finance a $100,000 rental property purchase. The average value of the mortgage for the year is $50,000 and the property produces $10,000 in rental income. Because your IRA’s average indebtedness was 50% of the property value, this fraction is applied to the rental income of $10,000 to calculate a UDFI of $5,000. That $5,000 is then taxed at the trust rate to determine how much UBTI will be owed to the IRS.

The UDFI related to this property should decrease over time as your IRA pays down the mortgage.

What type of legal or business structures trigger UBTI or UDFI?

LLCs and LPs are considered pass-through entities, meaning that any taxes due are the responsibility of the owner of the entity to pay. In this case, the owner is your IRA.

Given the tax implications associated with the use of retirement funds, it is important to consult with a professional who can help you determine the proper structure for the type of investment you are considering for your IRA and to help you optimize your specific tax situation. Custodians, like PENSCO, cannot advise on UBTI or UDFI.

If gross income of $1,000 or more is generated from UBTI or UDFI during the previous tax year, you are required to file IRS Form 990-T by the Tax Day filing deadline and pay the associated taxes. Taxes generated by UBTI or UDFI in your IRA must be paid with IRA funds and not your personal funds. 

Because tax situations are complex, PENSCO strongly recommends that you work closely with a financial professional who has expertise in this area. A CPA can help with the proper tax forms that need to be filed to account for UBTI, like the K-1 for the business and reporting taxes to the IRS on Form 990T.

 

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.

Editor’s Note: This is an updated version of a post we originally published in March 2015. We welcome new comments and questions below.