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Tax Considerations (Return to Self-Directed IRAs)
Clients enjoy the benefits of using self-directed IRAs to grow their investments tax-deferred in the case of a traditional IRA or tax-free in the case of a Roth.
However, there are circumstances in which the income produced by an investment in your IRA could trigger certain types of taxes. It’s important for you to understand the factors that trigger Unrelated Business Taxable Income (UBTI) and/or Unrelated Debt-Financed Income (UDFI) when making investment decisions using IRA funds.
Some factors to be aware of:
· The type of company or entity you are investing in. For example, is it an operating company, i.e. a company that produces income from selling goods and services? What is the legal structure of this company, i.e. LLC, LP, private corporation, etc.?
· If you’re investing in real estate, are you paying with cash currently within the IRA or borrowing funds from a bank (through a non-recourse loan) to purchase the real estate in your IRA ?
· Are you forming a legal or business structure to make the investment using IRA funds, i.e. LLC, LP, etc.? The legal structure can impact the type of tax you’ll pay, UBTI? Corporate or Trust? Compare to personal income tax if you were to use non-retirement funds?
· Your tax bracket and overall tax situation
Because every situation is unique, it is important that you consult with a CPA or attorney. See below for some general information and links to IRS resources for more detailed information.
Unrelated Business Taxable Income (UBTI)
What is it?
UBTI is a unique tax enacted by Congress in 1950 that 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 that unrelated business.
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, the income it produces from selling goods and services 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.
What is an Operating Company?
A company that makes a good or provides a service that it then sells to customers or clients. An operating company differs from a holding company whose main function is to own other companies.
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.
With the tax implications associated with the use of retirement funds, it is important to consult with a professional to help you with the proper structure for the type of investment being considered – and help you optimize your specific tax situation. If taxes need to be paid, you will want to optimize your tax situation.
Are there investments I can make with my IRA that will not trigger UBTI/UDFI?
Yes, there are many, and to name a few, you can invest in hedge funds, notes, REITS, and private corporations that are not LLCs or LPs.
In situations where UBIT could occur, you would want to consult with your CPA to help you determine if an investment you’re considering is worth paying the UBIT taxes if the income from the investment is greater than the taxes you pay. It is always best to consult with a professional to optimize your specific tax situation.
How do I know if I owe taxes generated by UBTI or UDFI?
As your custodian, PENSCO cannot advise on or calculate UBTI or UDFI. It is strongly recommended that you work closely with a tax professional who has expertise in this area if you are considering an IRA investment that may generate UBTI and to determine what taxes, if any, you may face.
Please note that taxes generated by UBTI or UDFI in your IRA must be paid with IRA funds and not your personal funds.
The IRS provides detailed guidance on UBTI here.
Unrelated Debt-Financed Income (UDFI)
What is it?
If a property purchased in an IRA is financed by debt, income produced by that property is subject to UDFI tax. An average indebtedness is calculated for the year, and only that portion of the income is taxed as UDFI.
What’s an example?
Let’s say you take out a mortgage to finance a $100,000 rental property purchase in your IRA. The average value of your mortgage for the year is $50,000 and the property produces $10,000 in rental income. Because your average indebtedness was 50% of the property value, this fraction is applied to the rental income of $10,000 to calculate your UDFI of $5,000.
If you then sell the property for $140,000 at the end of the year, your average indebtedness of 50% will also be applied to your gain to calculate UDFI. Your UDFI is therefore 50% of your $40,000 gain, or $20,000.
How do I know if I owe taxes generated by UDFI?
As your custodian, PENSCO cannot advise on or calculate UBTI or UDFI. It is strongly recommended that you work closely with a tax professional who has expertise in this area if you are considering an IRA investment that may generate UBTI and to determine what taxes, if any, you may face.
The IRS provides detailed guidance on UBTI here.
How do I report it?
UDFI is calculated and reported on IRS form 990-T. Additional rules for debt-financed property and income tax are available here.
How do I pay the taxes on UDFI?
Taxes on UDFI in your IRA must be paid with IRA funds (not personal funds). For more information, please see these instructions.
For our Clients: UBTI tax is generally reported on the IRS Form Schedule K-1 which will be provided to you by your investment sponsor. UBTI and UDFI must be reported on IRS form 990-T. For more information about reporting UBTI and/or UDFI, please read these instructions.
Because these factors can be complex, it’s important you consult with a tax professional to help you with your unique situation. If you need help finding a tax professional, check out our Professional Resources.