The tax advantage of an IRA is that income is tax-free until distributed. In general, an exempt organization is not taxed on its income from an activity that is substantially related to the charitable, educational, or other purpose that is the basis for the organization’s exemption. Such income is exempt even if the activity is a trade or business. However, to prevent tax-exempt entities from competing unfairly with taxable entities, tax-exempt entities are subject to unrelated business taxable income (UBTI) when their income is derived from any trade or business that is unrelated to its tax-exempt status.
What is UBTI?
UBTI is defined as “gross income derived by any organization from any unrelated trade or business regularly carried on by it” reduced by deductions directly connected with the business. An exempt organization that is a limited partner, member of a LLC, or member of another non-corporate entity will have attributed to it the UBTI of the enterprise as if it were the direct recipient of its share of the entity’s income which would be UBTI had it carried on the business of the entity.
Related: What is the UBTI Tax Rate?
Debt-Financed Property
UBTI also applies to unrelated debt-financed income (UDFI). “Debt-financed property” refers to borrowing money to purchase the real estate (i.e., a leveraged asset that is held to produce income). In such cases, only the income attributable to the financed portion of the property is taxed; gain on the profit from the sale of the leveraged assets is also UDFI (unless the debt is paid off more than 12 months before the property is sold).
There are some important exceptions from UBTI: those exclusions relate to the central importance of investment in real estate – dividends, interest, annuities, royalties, most rentals from real estate, and gains/losses from the sale of real estate. However, rental income generated from real estate that is “debt financed” loses the exclusion, and that portion of the income becomes subject to UBTI. Thus, if the IRA borrows money to finance the purchase of real estate, the portion of the rental income attributable to that debt will be taxable as UBTI.
Related: UBTI and Real Estate Investing
Regularly Carried on Business
For an IRA, any business regularly carried on or by a partnership or LLC of which it is a member is an unrelated business. For example, the operation of a shoe factory, the operation of a gas station, or the operation of a computer rental business by an LLC or partnership owned by the Self-Directed IRA LLC would likely be treated as an unrelated business and subject to UBTI.
Although there is little formal guidance on UBTI implications for self-directed real estate IRAs, there is a great deal of guidance on UBTI implications for real estate transactions by tax-exempt entities. In general, Gains and losses on dispositions of property (including casualties and other involuntary dispositions) are excluded from UBTI unless the property is inventory or property held primarily for sale to customers in the ordinary course of an unrelated trade or business. This exclusion covers gains and losses on dispositions of property used in an unrelated trade or business, as long as the property was not held for sale to customers.
In addition, subject to a number of conditions, if an exempt organization acquires real property or mortgages held by a financial institution in conservatorship or receivership, gains on dispositions of the property are excluded from UBTI, even if the property is held for sale to customers in the ordinary course of business. The purpose of the provision seems to be to allow an exempt organization to acquire a package of assets of an insolvent financial institution with assurance that parts of the package can be sold off without risk of the re-sales tainting the organization as a dealer and thus subjecting gains on re-sales to the UBIT.
Learn More: UBIT and House Flipping
IRA Unrelated Business Taxable Income Rules
When it comes to using a Self-Directed IRA to make investments, most investments are exempt from federal income tax. This is because an IRA (individual retirement account) is exempt from tax pursuant to Internal Revenue Code 408 and Section 512. However, you should be aware of the UBTI rules.
The Internal Revenue Codes exempt most forms of investment income an IRA generates from taxation. Some examples of exempt income include:
- Interest from loans
- Dividends
- Annuities
- Royalties
- Most rentals from real estate
- Gains/losses from the sale of real estate
However, the IRS set forth rules in the 1950s to prevent charities, and later IRAs, from engaging in an active trade or business. Charities and IRAs had an unfair advantage due to their tax-exempt status.
IRA investors can find the UBIT rules under Internal Revenue Code Sections 511-514. These rules are classified as the Unrelated Business Taxable Income rules.
If you trigger the UBIT rules, the income you generate from activities will generally be subject to close to a 40% tax for 2024. Note – an IRA investing in an active trade or business using a C Corporation will not trigger the UBIT tax.
UBTI Rules (Unrelated Business Taxable Income Rules)
UBIT rules generally apply to the taxable income of “any unrelated trade or business…regularly carried on” by an organization subject to the tax. The regulations separately treat three aspects of the quoted words. “Trade or business,” “regularly carried on,” and “unrelated.”
Read More: How to Avoid Unrelated Business Taxable Income
Trade or Business
In defining “unrelated trade or business,” the regulations start with the concept of “trade or business” by Internal Revenue Code Section 162. This allows deductions for expenses paid or incurred “in carrying on any trade or business.”
Although Internal Revenue Code Section 162 is a natural starting point, the case law under that provision does little to clarify the issues. Expenses that individuals incur in profit-oriented activities not amounting to a trade or business are deductible under Internal Revenue Code Section 212. Therefore, it is rarely necessary to decide whether an activity conducted for profit is a trade or business.
The few cases on the issue under Internal Revenue Code Section 162 generally limit the term “trade or business” to profit-oriented endeavors involving regular activity by the taxpayer.
“Regularly Carried On”
The UBIT rules in connection with an IRA only apply to income of an unrelated trade or business that is “regularly carried on” by an organization. Whether a trade or business is regularly carried on is determined in light of the underlying objective to reach activities competitive with taxable businesses.
The requirement is then met by activities that “manifest a frequency and continuity, and are pursued in a manner generally similar to comparable commercial activities of nonexempt organizations.”
Short-term activities are exempt if comparable commercial activities of private enterprises are usually conducted on a year-round basis. For example, a sandwich stand that an exempt organization operates at a state fair would be exempt.
However, a seasonal activity is regularly carried on if its commercial counterparts also operate seasonally. For example, a horse racing track.
Intermittent activities are similarly compared with their commercial rivals and are ordinarily exempt if they don’t have promotional efforts typical of commercial endeavors.
Moreover, if an enterprise is conducted primarily for beneficiaries of an organization’s exempt activities (i.e., a student bookstore), casual sales to outsiders are ordinarily not a “regular” trade or business.
Before determining whether an activity is seasonal or intermittent, the relevant activity must be identified and quantified, a step that is often troublesome.
The type of income that generally could subject a Self Directed IRA to UBTI or UBIT is income from the following sources:
- Income from the operations of an active trade or business – i.e. a restaurant, gas station, store, etc.
- Business income generated via a pass-through entity, such as an LLC or partnership
- Using a non-recourse loan to purchase a property
- Using margin on a stock purchase
Contact IRA Financial
Do you still have questions regarding UBTI/UBIT rules in an IRA that were not covered in this article? We can answer your questions directly at 800-472-0646.
