Tax-advantaged individual retirement plans provide opportunities for long-term financial success, but sometimes offer surprises. There’s a misconception that distributions are the only taxable events inherent to retirement funds, though others may exist as well. Taxable income and income tax can occur INSIDE your self-directed IRA and must be paid from the account itself. Depending on the investment, your retirement plan may owe unrelated business income tax (UBIT). You may receive a Schedule K-1 for your IRA if income from the previous year was potentially subject to UBIT.
Need to know more about UBIT? Click here to download our Investor’s Guide to Unrelated Business Income Tax for IRAs.
What is a Schedule K-1?
Individuals or investment entities may mistake a Schedule K-1 for a simple reporting document like a Form 5498. As a result, self-directed investors may not fully understand the implications of receiving the form and may disregard it altogether.
To avoid the potential repercussions of unpaid UBIT, it’s important to understand the information provided on the Schedule K-1 document. You may need to complete a tax filing via Federal Form 990-T in accordance with this information.
Part III, Box 1 – Ordinary Business Income (Loss)
If there’s a positive figure in this box, your IRA will owe UBIT on the specified amount at the current trust rate. This operating income wasn’t taxed at the corporate level, so your retirement plan must pay those taxes in turn.
Part III, Box 2 – Net Rental Real Estate Income (Loss)
Unfortunately, you can’t always tell what portion (if any) of your retirement income is subject to tax. UBIT applies if your plan yielded income from debt-leveraged real estate, which may not show on the Schedule K-1. A number in Box 2 means you should contact your investment management team to find out which portion of the indicated figure is subject to UBIT. You may not owe UBIT on the full figure, as the taxable amount will depend on the debt-to-equity ratio of your plan’s real estate holdings.
Part III, Box 3 – Other Net Rental Income (Loss)
This box will show rental income in a similar manner to Box 2, except these earnings won’t be related to real estate. This rental income is not exempt from income tax for retirement plans, so your account will be responsible for paying tax on any non-real estate rental income. For instance, if your IRA-held investment rents out equipment, earnings from those rentals will be indicated in Box 3. As with Box 2, the debt-to-equity ratio will apply when calculating UBIT.
Part III, Box 19 – Distributions
This describes any money disbursed to your retirement plan, which may not match the figure in Box 1. If the figure is lower, it means the operating business has not yet issued cash earnings in full. If the figure is higher, the company paid amounts that were earned in prior years or returned capital contributions. However, taxes are calculated by the income described in Box 1, not the distributed amount described in Box 19.
The Bottom Line
It may seem like a burden, but UBIT (like any income tax) can be an indicator of success. As such, don’t let it discourage you from pursuing potentially lucrative investments in operating companies or debt-leveraged real estate. Profits retained after UBIT will remain in your IRA and no additional taxes will apply until you start taking distributions (for pre-tax accounts like Traditional IRAs).
Please don’t hesitate to give us a call at 877-742-1270 or submit a secure inquiry through the Client Portal with any other questions or concerns about IRA investing and UBIT.