One of the most complicated areas of self-directed IRAs is Unrelated Business Income Tax (UBIT). It is commonly called UBIT. In certain situations, an IRA can owe taxes. UBIT will apply to specific types of accounts: Traditional IRAs, Roth, Simple, SEP and Educational Savings Plans (ESA). UBIT will not apply to 401(k) plans. It is important to discuss with your tax advisor the consequences of UBIT and how it will affect you. Basically, tax is owed on the non-IRA portion of an investment; usually it applies to the financed portion of investment.
Typically, an IRA will owe Unrelated Business Income Tax in one of three circumstances:
- When an IRA owns real estate that has financing attached
- When an IRA owns an LLC that is an operating company (unrelated trade or business)
- When an IRA receives rents on personal property
The first two examples are the most common. Many clients who purchase real estate finance a part of the purchase. This is a viable solution, but the IRA holder must be aware of two important facts. The IRA can borrow money, but it must be nonrecourse financing. This type of financing is characterized by the fact that the IRA is borrowing the money with the property as the only collateral. The IRA owner cannot personally guarantee the loan. With nonrecourse financing, the lender will usually require a larger down payment but because the property is the only collateral, the lender wants to be well secured. In the first example, UBIT is the tax that is due on the net income from the debt financed portion of the asset. It does not matter if the IRA owns the asset or the asset is held by an LLC that is held by your IRA. For example, if you have a property that has debt of 40%, 40% of the net income (assuming it is net rental income) is subject to UBIT.
Second, Unrelated Business Income Tax will be due if you are running a business in your IRA. If your IRA owns stock in a C Corporation, the C Corp will pay its own tax and distribute a dividend to the shareholder (your IRA). If your IRA owns an LLC, someone must pay the tax, and this is where UBIT applies. This is true for any type of operating business the IRA owns. This is where the fine line is drawn. If you are a real estate investor buying and flipping foreclosures outside your IRA but now you decide to start conducting the same business with your IRA funds, this income will probably be subject to UBIT tax. This is one area where you need experienced tax help.
On a planning note, if you are considering purchasing real estate with debt, it might be better to set up an Indy K plan to avoid the Unrelated Business Income Tax. Under current law, IRA laws are in Section 408 of the Internal Revenue Code and Pension Plans are covered in section 401. The laws governing section 401 do not require that UBIT be paid and are generally more lenient. The additional work for a 401k could be a huge savings in UBIT.
So how is Unrelated Business Income Tax calculated? UBIT is calculated a few different ways. For rental property, there are actually two taxes – UBIT tax on net rental income and Unrelated Debt Financed Income based on the capital gain sale.
As I mentioned above, UBIT is based on a percentage that is calculated on the average percentage of debt on the property for the last twelve months. So if the average debt (loan to cost ratio) is 50%, then 50% of the net rental income is subject to UBIT. Typically in an IRA, you cannot deduct interest or depreciation; however, when calculating UBIT, 100% of the interest is deductible and the percentage of the depreciation is deductible. This can substantially lower the net income and reduce the tax due.
The tax due for UBIT is reported on form 990-T and the rates are based on the current Trust Tax Rates. These rates do accelerate faster than corporate or individual rates. The return only needs to be filed in years there is tax due.
The second tax I mentioned is Unrelated Debt Financed Income Tax. Basically this is capital gains tax on the profits from the sale of the real estate. This tax again is based on the current capital gain tax rate and filed on Form 990-T. ***It is important to note that if you are going to buy another piece of real estate, you can do a 1031 exchange inside the IRA and avoid Unrelated Debt Financed Income. This is easy and can be a huge savings for the IRA owner. Setting up an LLC does not avoid UBIT tax with regard to real estate or any other investment held by the IRA.
As previously mentioned, Unrelated Business Income Tax can apply if you are running an operating business in your IRA. Most often, this is not an issue if structured properly. The issue can occur if you start investing with your IRA and it turns into a business. If this does happen, it needs to be address and corrected accordingly.
UBIT can be extremely complex to consider theoretically and to figure out the first year. However, after the first year it is basically updating the number and recalculating the amount. The typical client who is interested in self-direction is one who doesn’t mind doing their research and this is just one more step of controlling their retirement account. But it is very important to get knowledgeable tax advice up front and make sure your assets are structured properly. This is one of those times when a little planning goes a long way.
Midland Trust has an arsenal of tax free strategies; feel free to contact us for more information or questions at (239) 333-1032.