The primary advantage of using a Self-Directed IRA to make investments is that, in general, all income and gains from the IRA investment are exempt from federal income tax. In other words, the income and gains from the Self-Directed IRA investment flow back to the IRA without tax, which is known as tax deferral or tax-free growth in the case of a Roth IRA. The reason for this is that Internal Revenue Code Sections 408 and 512 exempt most passive forms of investment income generated by a Self-Directed IRA from federal income taxation. The most common forms of passive income exempt from taxation include interest dividends, royalties, rental real estate income, and capital gains. However, in certain instances, a little-known tax known as the Unrelated Business Taxable Income (UBTI) tax could be triggered and turn a tax-advantageous investment into a taxable investment.
- UBTI can turn a tax-advantageous investment into a tax nightmare
- Learn when the UBTI tax applies
- Avoiding the extra tax may be possible in certain situations
What is Unrelated Business Tax?
For many retirement account investors, there is no reason that they would have ever heard of the UBTI tax. The main reason for this is that the majority of IRA or 401(k) plan investors invest in traditional types of investments, such as equities, mutual funds, and ETFs, which do not trigger the application of the UBTI tax rules.
In general, the UBTI tax is triggered in three types of investment categories involving retirement accounts:
- Using margin to buy stocks or securities
- Using a non-recourse loan to acquire real estate (there is an exemption for 401(k) plans under certain conditions). The loan cannot be guaranteed by the IRA owner pursuant to the IRS-prohibited transaction rules.
- Investing in an active trade or business operated through an LLC or pass-through entity, such as a partnership.
IRC Section 511 taxes UBTI at the trust tax rates, which is quite high. For 2024, the highest trust tax rate is a whopping 37%!
Related: IRA Financial’s in-house Tax Filing Services
What are the Filing Requirements for UBTI?
In computing UBTI, a specific deduction of $1,000 is permitted. If a Self-Directed IRA LLC has a gross UBTI of $1,000 or more during its fiscal year, it must file a completed IRS Form 990-T to report such income and pay any taxes due. Form 990-T is due at the same time as Form 990.
How to Avoid Unrelated Business Taxes?
Investment vs. Business
In general, the determination of whether a transaction or series of b transactions involving a Self-Directed IRA will trigger the UBTI tax is based on the facts and circumstances on whether the activity rises to a trade or business versus a passive investment.
A trade or business is defined as any activity which is carried on for the production of income from the sale of goods or the performance of services. Regarding the requirement that the trade or business be “regularly carried on,” the essential inquiry is as to the frequency and continuity of the activities
In other words, for a Self-Directed IRA investment to be deemed a business versus a passive investment, the activity must be carried out on a regular basis with the intent to produce income. In most cases, it is clear whether an activity will be deemed a business versus a passive activity. However, in the case of real estate, the determination of whether the real estate activity is deemed a business and, thus, subject to the UBTI tax, is dependent on the following factors:
- Frequency of transactions
- Level of continuity
- Level of improvement
- Intent
- The proximity of sale to purchase
- The purpose for which the asset was acquired
- Personal activities of the taxpayer
C Corp Blocker
Using a C Corporation to block the application of the UBTI tax is a popular way used by many investment funds. A C Corporation is taxed as a separate entity from its shareholders and is subject to a corporate entity tax. Whereas a pass-through entity, such as an LLC, is deemed a flow-through entity because there is no entity level tax. All LLC income and gains flow through to the members where the members pay tax on the income.
Therefore, if a Self-Directed IRA uses a C Corporation to invest in a business or fund, the income and gains would be subject to corporate income tax, which is currently taxed at 21% in 2023 on the net corporate income but would not be subject to the UBTI tax. This is because a C Corporation blocks the flow-through of the UBTI tax. This is why most IRA investors have never heard of the UBTI tax since most IRAs are invested in publicly traded company stocks, which are almost exclusively set up as C corporations and not LLCs.
A C Corporation blocker solution will not erase tax due from the income or gains from a Self-Directed IRA investment, but it will limit the tax to 21% versus the maximum UBTI tax rate of 37%.
For example, if a retirement account investor is seeking to invest retirement funds into an active business operated through an LLC, such as a retail store, he or she can establish a C Corporation, invest the IRA funds through the C Corporation, and then have the C Corporation invest the funds into the retail store LLC. All income received by the C Corporation would be subject to the now-reduced corporate tax rate of 21%.
Read More: UBTI Tax & The Corporation Blocker
Debt Vs. Equity
If a Self-Directed IRA can structure an investment into a flow-through business or fund as a loan versus equity, the Self-Directed IRA would not be subject to the UBTI tax. This is because interest on a loan is exempt. However, the debt must be real debt and not be equity disguised as debt. For example, the loan must have a stated rate of return and the return cannot be based on the profits of the business or on a certain investment goal.
The downside of structuring a Self-Directed IRA investment as a loan versus an equity investment is that the loan returns are typically capped at the interest on the loans, whereas, equity investments typically do not have a cap since the equity can be worth as much of the company or fund sells for in the future.
Manage Your Real Estate Investment
The UBTI tax is only triggered if the net income or gains allocated to the Self-Directed IRA is above $1,000 for the taxable year. Thus, if you can keep the net income or gains from your investments below that amount, no UBTI tax would be due. For most business and investment fund investments, this may not be possible since the Self-Directed IRA will likely not have control over the operations of the business or the fund.
However, in a direct real estate investment by a Self-Directed IRA, where the IRA owner has more control over expenses, such as debt payment servicing, managing the cash flow of the real estate investment is a possibility. For example, if a Self-Directed IRA bought a home and used IRA funds and a nonrecourse loan, the IRA owner could try increasing loan payments, accelerating depreciation, or making improvements to reduce the net cash flow below the $1,000 amount.
Learn More: Real Estate Investments with a Self-Directed IRA LLC
Contact Us
A Self-Directed IRA investor interested in using retirement funds to invest in an active business operated through a pass-through entity or plans on using a non-recourse loan to acquire real estate should be mindful of the potential application of the UBTI tax rules and consider the potential workarounds provided above. Fill out the form below if you have any questions related to the application of the UBTI tax.
