The self-directed IRA, Pt. 5: current IRA taxes (UBTI & UDFI)
By Warren L. Baker
Editor’s note: In a continuing series of articles, tax attorney Warren L. Baker is writing on the topic of self-directed IRAs – from the basic formation process to the complex tax and legal ramifications involved when investing using these structures.
When looking at the world of self-directed IRAs from the 10,000 foot level, there are two categories of legal/tax issues that are the most critical when investing an IRA into non-traditional investments (e.g., real estate, privately-held businesses, hard-money lending, tax liens, etc.).
The first and most important problem to avoid is triggering the automatic invalidation of the IRA, or IRA-owned LLC, by having the structure enter into a prohibited transaction. If a prohibited transaction occurs, many of the other issues become irrelevant because the IRA loses its tax-exempt status (i.e., the assets in the IRA become the personal assets of the IRA holder, significant tax consequences are triggered, and the IRA ceases to exist).
However, assuming no prohibited transaction has occurred, the second major issue is whether the IRA’s (or IRA/LLC’s) investments are triggering current taxes at the IRA level. Unfortunately, this issue is often ignored due to the IRA account holder’s false assumption that income to an IRA is always exempt from tax. This is definitely not true.
Active business income – UBTI:
Earnings within an IRA (or IRA/LLC) are generally exempt from tax. However, certain investments create taxable income called unrelated business taxable income. UBTI is income from a trade or business regularly carried on by the IRA which is not substantially related to the exercise by the IRA of the IRA’s tax-exempt purpose. Interestingly, the tax code defines any active trade or business to be unrelated to the IRA’s purpose.
However, there are statutory modifications that specifically exclude certain types of income out of UBTI. These include, but are not limited to:
- dividends (e.g., paid to the IRA as a result of the IRA owning C Corporation stock);
- interest (includes points);
- rent from real property;
- sales proceeds from real property (assuming the property is not held as inventory or held in the ordinary course of the IRA’s business, e.g., flipping or development activity).
In an ideal world, the tax on UBTI puts IRAs on an equal playing field with other active businesses. However, because an IRA is taxed on UBTI at trust rates (which are very condensed – i.e., it doesn’t take very much income to get into the top tax bracket), an IRA can actually owe more tax than a similarly- situated individual who is operating the exact same business. UBTI examples:
1. IRA purchases a coffee shop and pays unrelated third-parties to operate the business (recall that no disqualified person can be financially involved). The income from the coffee shop will be treated as UBTI to the IRA.
2. IRA purchases 10 percent of a project LLC (or partnership) that invests into a fix and flip real estate strategy. Because the real estate is being held as inventory, income flow-through to the IRA will be subject to UBTI. Further, because the IRA would be taxable on the UBTI whether the project distributed profits back to the IRA or not, the IRA could run into a major liquidity problem (i.e., it could have a tax liability but no cash to pay the tax. Note: the IRA account holder definitely cannot pay this tax on behalf of his or her IRA).
3. IRA makes a loan to an operating business structured as an LLC or partnership. Rather than only interest being paid back to the IRA, the business agrees to pay a percentage of its profits. The income associated with the disguised equity will likely be subject to UBTI because it does not constitute interest.
Note: All of these examples apply equally regardless of whether the IRA invests directly or through an IRA/LLC structure.
Debt-financed income – UDFI:
Another way for an IRA’s income to be treated as UBTI and be currently taxable is under the unrelated debt-financed income rules. UDFI is triggered when the IRA receives (either directly or indirectly through a flow-through entity, like an LLC or a partnership) income from debt-financed property.
For example, if an IRA purchases a piece of rental real estate using partial debt-financing (either seller financing or bank financing), UDFI will be triggered. However, because UDFI only applies to the percentage of income resulting from the debt-financed portion of the property, UDFI will generally result in less tax being owed than in the UBTI situation discussed above. This makes logical sense because the percentage of income resulting from the capital invested by the IRA (rather than the amount borrowed) should normally result in tax-exempt income.
IRA purchases a piece of real estate using a 40 percent down payment and 60 percent seller financing. The property is then rented out long term to unrelated third-parties. Although the rental income would be completely exempt from current tax if the IRA purchased the property outright, in this situation 60 percent of the rental income would be subject to the UDFI tax calculation. However, the tax impact will be reduced because 60 percent of the expenses (e.g., depreciation) from the property can be used to offset the UDFI income. Note: Because a disqualified person (e.g., the IRA account holder) cannot be personally liable for debts of the IRA (or IRA/LLC), any debt involved in these examples must be non-recourse. The practical result of this requirement is that the IRA will likely have to put down at least 40 percent of the purchase price and pay interest at a higher rate.
IRA tax filings:
If an IRA generates gross income subject to UBTI or UDFI of more than $1,000 during the taxable year, the IRA must file Form 990-T (generally by April 15th) and pay a tax. This raises many potential issues/problems, including:
1. In order to file the 990-T, the IRA must be issued a federal tax ID number (EIN).
2. Self-directed IRA custodians often do not have the information necessary to file the 990-T because the IRA is invested into privately-held entities (e.g., LLC) and the investment paperwork related to those entities is sent directly to the IRA account holder. This problem is always present in situations where the IRA’s only investment is the 100 percent ownership of an LLC, which in turn makes all of the investments (facilitators like to advertise these structures as having checkbook control).
3. Despite the instructions for Form 990-T stating that the fiduciary is responsible for filing the tax return, many self-directed IRA custodians state in their custodial agreements that the IRA account holder is responsible for filing any applicable tax returns. Therefore, it is vital for the IRA account holder to be properly educated on the UBTI/UDFI rules.
Unfortunately, most facilitators and custodians do not give specific guidance in this area because they do not want to be viewed as giving legal advice. The end result is a bit of a tax reporting black hole and the potential for large penalties and interest imposed by the IRS.
4. An IRA subject to UBTI/UDFI must file on-going quarterly estimated tax payments in the same manner as a corporation. In other words, after the first 990-T is filed, the IRA must make payments every three months.
5. Many accountants/CPAs are not very familiar with Form 990-T, which can result in the IRA account holder (and manager of the IRA/LLC) scrambling to find a tax professional that can sort out these issues.
Despite all of these potential UBTI/UDFI issues, with appropriate up-front advice and back-end tax compliance support, all of these issues can be readily addressed.