Some retirement investors are hesitant to invest in assets that may incur unrelated business income tax (UBIT) because they see it as a penalty or as excessive tax. However, in the case of retirement accounts, UBIT means the account is making money. It is not a penalty, but a cost of doing business.
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First, UBIT can occur when owning a “pass-through” or untaxed entity that owns and operates a business. UBIT can also occur on debt-financed IRA purchases. This could include when the investment uses leverage like a non-recourse loan for real estate, or if the IRA invests in a company that uses debt-leverage. In both cases, the percentage of profits that is derived from the debt-leverage could incur UBIT. For real estate, if a property has outstanding debt-leverage associated with it when it’s sold, UBIT would apply to the debt-leveraged profits.
Unrelated debt-financed income (UDFI) and unrelated business taxable income (UBTI) trigger UBIT. UDFI occurs when an IRA takes out a loan in order to increase its buying power. Debt-leverage can be used to purchase a rental property that the IRA does not have the funds to cover. The loan must be a non-recourse loan, meaning the collateral that’s associated with that loan is the account-owned asset itself.
There are two chunks of money associated with the purchasing of the asset, which make up two different percentages of ownership. The first is the down payment, which comes directly from the IRA money that’s been deposit into the IRA. The second is the debt-leveraged money that comes from outside the IRA. UBIT only applies to the percentage of the net-income that’s attributed to debt financing (after deductions, including depreciation). You can take deductions like depreciation and expenses to potentially mitigate the amount of net income that is subject to UBIT.
UBIT also applies to rental income from real property as the property moves through time. Form 990-T is like a 1040 for your IRA. This form functions as the tax return for your IRA and is where you calculate if UBIT is due. Upon sale of the IRA property, UBIT applies to the sale of a property based on the debt-leveraged portion.
UBTI occurs when an IRA invests in an operating business or an entity (such as an LLC, LLP, etc.) that is not paying business tax. UBIT will probably occur on all profits associated with that business. Almost any business your IRA would invest in would not be part of the tax-exempt purpose of UBIT (to level the playing field for businesses in competition with non-profits). So, if you invest in a business with your IRA, make sure you file a Form 990-T and calculate UBIT.
Believe it or not, fix-and-flip projects can be considered an ongoing business, even if the investments are not debt financed. Therefore, investors who perform non-leveraged fix-and-flip investments may incur UBIT.
Despite UBIT, with leverage you can still make more money for your IRA than you would have without it. Debt-leverage is the only strategy allowed by the IRS that will let you make money on money that you didn’t have to contribute to the IRA for your retirement. Unlike debt-leverage, all the other money put into your IRA had to follow annual contribution limits. When considering whether or not you should leverage your IRA to make a real estate purchase, do the calculations. Some factors to consider include but are not limited to:
As the account holder, it’s up to you to decide about your IRA’s participation in debt-leverage and subsequently UBIT. If you loan money to an entity, you won’t accrue UBIT. However, if you buy private equity in an entity that owns a business with debt-leverage, it is possible for UBIT to apply. If you buy property without leverage, you will avoid UBIT. If you buy a larger and potentially more lucrative property with leverage, UBIT is once again possible.
Because UBIT is not incurred by the IRA receiving income such as dividends resulting from C-Corp stock, rent from real property, or interest from an IRA loan , it is possible to avoid UBIT even when you invest in an ongoing business or real estate.
Who pays the tax bill? The IRA pays the UBIT, not the IRA account holder. When are tax payments necessary? UBIT tax payments are necessary if the IRA generates taxable net income over $1000. Like you may set up outside of your IRA, quarterly estimated payments may be advantageous.
When debating the pros and cons of fixing-and-flipping properties within an IRA, investors shouldn’t be asking, “How do I avoid UBIT?” but rather, “How much will the IRA grow if I fix-and-flip properties and pay UBIT?” or “What is the resulting rate of return within my IRA?”
Dismissing an investment because of the potential payment of taxes can keep an investor from making an otherwise lucrative investment. Consult with your legal and tax advisors regarding investments involving potential UBIT within your IRA. To address questions or concerns related to your self-directed IRA, please don't hesitate to give us a call at 877-742-1270 or send us an e-mail at email@example.com.