Potential Taxes with Self-Directed IRAS
Your self-directed IRA may incur unrelated business income tax (UBIT) when borrowing funds to invest and/or if running a business as an investment in your plan. It is important to understand when UBIT is incurred, how it works with UDFI and UBTI, and to ensure your IRA follows IRS guidelines.
Some investors hesitate to invest in assets that may incur UBIT because they see it as a penalty or an excessive tax. But it’s just a cost of doing business related to certain investment structures.
What is UBIT?
UBIT is a tax that your self-directed IRA may incur when:
- Your IRA receives unrelated business taxable income (UBTI) due to its ownership in a business that is not taxed as a C corporation.
- It earns unrelated debt-financed income (UDFI) from revenue like rent or proceeds from the sale of an investment property that has outstanding debt.
The Following Are Considered UBTI in an IRA
- If your self-directed IRA invests in a business and receives pre-tax profit instead of post-tax profit or dividends
- Income made by a business your IRA actually owns and operates
- Income your IRA receives from assets held within a business operation or entity (such as a partnership or an IRA LLC) that did not pay business tax on the profit before distributing income to the retirement account
How Does an IRA Earn UDFI?
When any portion of an investment in your IRA is purchased with financing and generates a profit from this investment, the income generated by the debt-financed portion of the investment is considered unrelated debt-financed income. The percentage of net profit attributed to the portion of the investment owned by your IRA is tax-sheltered. But the percentage of net profit generated by the financed portion is considered UDFI and is subject to UBIT. However, any expenses and depreciation of the property can be calculated to offset the tax liability.
- UBIT from UBTI does NOT apply to investments into C corporations as C corporations pay tax at the corporate level and then pass dividends to shareholders.
- Interest, rent (from a property without debt), royalties, and dividends received from investments are not subject to UBIT.
- UBIT is not a personal tax; your IRA pays it. Your IRA has its own tax ID number and must file Form 990-T.
- UBIT tax rates follow trust tax rate schedules, not individual income tax rates. An exception may apply if your IRA sells property that has outstanding debt.
- When calculating potential UBIT, your IRA may be able to use deductions to reduce the tax.
- Fix-and-flip real estate income is generally considered business income (UBTI).
7 Ways to Reduce or Avoid UBIT
- Don’t allow your IRA to use leverage to fund your real estate investment. UBIT only applies to the debt-leveraged percentage of net profit of an asset.
- Partner your IRA funds with cash or another investor instead of using leverage.
- Use a solo 401(k) as they generally do not have to pay UBIT from UDFI.
- Use “banked” losses from previous years to offset profits in the current year.
- Pay down debt leverage quickly with profits from other IRA investments.
- Pay off debt leverage a full twelve months prior to the sale of an IRA-owned property to avoid UBIT on sale profits.
- When investing in a business, choose a C corporation, which pays business tax before profits are disbursed to investors (including IRA investors), so no UBIT from UBTI occurs.
While UBIT is explained in IRS Publication 598, IRC 512 explains UBTI, and IRC 514 explains UDFI, you should consult with your accountant or other tax professional to ensure your IRA remains in compliance with IRS guidelines.