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What’s in a Word: Unrelated Business Taxable Income

Tag on Christmas Tree

  |  By Chris Shanahan, CISP®

I recently returned from the ADISA Spring Symposium Conference in New Orleans, where I participated in a panel discussion titled: "Self Directed IRAs: Considerations and Requirements for Sponsors, Brokers and Advisors."

The conference is aimed at professionals who offer and manage alternative investments, and many who attended the panel had questions about taxes and the circumstances in which the income produced by an investment in an IRA could trigger taxable income.

First, let me stress that I am not a CPA or a tax lawyer, and it is always best to work with a financial professional before making any investment decisions.

Second, I want to emphasize that the investment income generated by most passive investments held in your IRA -- like dividends, gains on the sale of real estate or interest from loans -- are exempt from taxes. After all, one of the perks of a self-directed IRA is that they allow you to grow your investment tax deferred in the case of traditional IRAs or tax free in the cash of a Roth.

But with Tax Day on the horizon it’s important to understand how an investment in your IRA could produce Unrelated Business Taxable Income or Unrelated Debt-Financed Income and be subject to taxes.

How might your IRA owe taxes?

Let’s take 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 income so it’s not subject to taxes. But then the IRA pays to make improvements to the land and turns it into a Christmas tree farm. Suddenly, the investment is no longer passive and it is instead producing an income stream selling Christmas trees. The improvement of the land and the sale of these trees mean the IRA could be subject to Unrelated Business Taxable Income (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. UBTI can affect IRAs, including Traditional IRAs and Roth IRAs as well as qualified plans.

What does "Unrelated Business" mean for IRAs?

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.

IRAs are considered by the IRS to be a tax-exempt or tax-deferred entity for the purpose of saving for retirement. So 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. 

How else might UBTI be triggered?

If a property purchased by an IRA is debt-financed, income produced by that property could be considered Unrelated Debt-Financed Income (UDFI), a sub-set of UBTI, 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.

How do I know if I owe taxes generated by 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 April 15th 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, it is strongly recommended 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.