Volume 24 Issue 4 -- July/August 2012
In recent years there has been increased interest in, and promotion, of self-directed IRAs (SD-IRAs) because of their investment flexibility. SD-IRAs are generally tax exempt, although any assets in an IRA are taxed as ordinary income upon withdrawal.
IRAs can, however, become subject to the Unrelated Business Income Tax (UBIT), which is a tax on activity that is deemed to be unrelated to an entity’s tax exempt purpose. The UBIT rules can cause surprise for SD-IRA owners.
UBIT potentially applies to almost any type of business activity. For example, if an IRA invests in a retail business partnership, the IRA’s share of partnership income would be subject to UBIT. There are, however, a number of important exceptions.
UBIT applies to “unrelated business taxable income” (UBTI), which is broadly defined but subject to a number of significant exceptions. For example, interest, dividends, and real property rents are excluded from UBTI.
There is, however, one very important limitation on these exclusions that applies to income from “debt financed property.” “Debt-financed property” is income producing property (such as real estate or securities) purchased in whole or in part with debt. In such cases, the income attributable to the debt-financed portion of the property is taxed as UBTI. Gains on the sale of the leveraged assets also are included in UBTI unless the debt is paid off more than 12 months before the sale.
UBTI is taxable at the rates applicable to trusts and estates. There is little authority on whether capital gains rates apply if a SD-IRA’s UBTI includes net capital gain.
Suppose an IRA owner self directs the IRA to invest in real estate costing $250,000. The purchase is financed with a $100,000 mortgage. (Because neither an IRA owner nor the IRA assets can be exposed to liability for any mortgage, the mortgage must be non-recourse.) In this instance, the mortgage balance is 40% of the property’s cost, so 40% of the net rental income from the property is UBTI.
Investing in a partnership or LLC that incurs debt to buy property will not change the result. The IRA-partner’s share of both the income and the debt will be attributed to the IRA and render the debt-financed rental income subject to UBIT.
The UBIT tax bill must be paid by the IRA, not the IRA owner. Obviously there must be sufficient cash flow within the IRA to pay these taxes. The IRA will also need a bank account to pay the tax.
The exclusions from UBTI for rent or interest are based on substance, not form. It is essential that the arrangement be a true loan or rental arrangement. Thus, even though the payments may be called “rent,” if the substance of the arrangement is something more akin to a partnership, the “rent” payments may be recharacterized as non-rental payments and thus lose the UBTI exclusion.
For example, if the “rent” includes payments based on the lessee’s net profits, the income could be deemed to be partnership profits rather than rent. Similarly, loans that involve equity participation payments could trigger UBIT.
Rents attributable to personal property leased with real property can cause the rent to be UBTI if the rents attributable to the personal property exceed 10% of the total rents from the property.
If a self-directed IRA generates more than $1,000 in gross UBTI, it must file Form 990-T. To determine whether this threshold is reached, an IRA owner must aggregate all of his or her individual accounts to determine if the total UBTI from all accounts is in excess of $1,000. An IRA that must file Form 990-T must also obtain an Employer Identification Number (EIN). An EIN may also be required to open the bank account that the IRA will need to pay any UBIT.
It is important to determine whether the IRA owner or the custodian will be filing any required 990-Ts. Many IRA custodial agreements for SD-IRAs expressly place the responsibility for filing any 990-Ts and paying the tax on the IRA owner.
If the total amount of UBIT that an IRA is required to pay annually exceeds $500, the IRA must also file and pay quarterly estimated taxes. Again, under many custodial agreements, paying any estimated taxes will be the IRA owner’s responsibility. Failure to pay required estimated taxes in a timely fashion can result in additional interest and tax penalties. Many states follow the federal rules for taxing UBTI.
Determining whether it is worth the cost of incurring UBIT with an IRA investment requires careful planning and analysis.If you have questions about self-directed IRAs , please contact Tax & Business Professionals.
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