One of the most powerful advantages of an IRA is tax deferral of income and appreciation prior to distribution. This allows an IRA value to grow undisturbed by income taxes. Any disturbance to the tax-deferred growth could decrease the future value of the IRA value. One tax area that could decrease the value of an IRA is called Unrelated Business Taxable Income, or commonly called UBTI. UBTI is a fairly complicated section of the tax code. The short version is that an additional tax will be levied on income earned in an IRA caused by UBTI.
Note: It is of utmost importance for you to seek and receive advice from qualified tax, legal, and financial advisors regarding any questions you have, or actions you plan to take, regarding how specific investments you plan to make inside your Self-Directed IRA can create UBTI and subject your IRA to additional income taxes.
We sought the help of Jason Helquist, MA, LL.M, and Chief Compliance Officer of the Provident Group, an individual who is proficient in the Self-Directed IRA field. According to Mr. Helquist, to help explain UBTI:
"The tax advantage of an IRA is that income is not taxed until distribution. However, to prevent tax-exempt entities from competing unfairly with taxable entities, Congress has made tax exempt entities subject to unrelated business taxable income ("UBTI"). UBTI occurs when a tax-exempt entity’s income is derived from any trade or business that is unrelated to its tax-exempt status. For an IRA, any business regularly carried on or by a partnership or corporation of which it is a member is an unrelated business. Although there is little formal guidance on UBTI implications for Self-Directed real estate IRAs, there is much guidance in the traditional tax-exempt context. This should act as persuasive authority and be illustrative of how the IRS would view transactions by Self-Directed IRAs. The fact that an UBTI occurs should not necessarily negate the use of any given asset class within an IRA. It should simply act as a one of many factors IRA owner should consider prior to investing.
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. UBTI also applies to unrelated debt-financed income ("UDFI"). "Debt-financed property" refers to leveraged assets or assets that a tax-exempt owner has purchased with borrowed money. In such cases, only the income attributable to the financed portion of the property is taxed.
There are some important exceptions from UBTI, which have additional importance where a Self-Directed IRA holds debt financed real estate assets. 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. For example, if the IRA purchases real estate for $200,000 with a $50,000 mortgage, then 25% of the rental income will be subject to UBTI. The UBTI must be paid by the IRA, not the IRA owner. Therefore, it is important to ensure that there is sufficient liquidity in the IRA or cash-flows generated from the real estate to pay the tax.
An IRA with $1,000 or more of gross UBTI must file a Form 990-T. An IRA owner must aggregate all of his or her individual accounts to determine if the $1,000 threshold is met. The IRA owner cannot avoid the UBTI by purchasing property that is already subject to an existing debt and assuming that debt. Such taxes obviously must be considered in deciding whether the overall expected rate of return of the investment warrants the investment.
It is important to note that the mere recognition of UBTI or UDFI does not compromise the overall tax exempt status of the IRA. As shown above, only the transactions generating the UBTI or UDFI trigger a tax. All other transactions or income generation by the IRA assets preserve the tax-deferred status.
It is also very important to remember that just because an IRA is subjected to UBTI, the overall income taxes caused by the UBTI could be insignificant. I always advise IRA owners to verify the projected income taxes from UBTI with their tax professional prior to investing." |
