Part 1: UBIT

Making investments with funds from a self directed IRA provides a great tax advantage in that most income is tax free until distribution.  However, there are certain situations in which a self directed IRA can generate taxable income in the form of Unrelated Business Taxable Income (UBTI) or Unrelated Debt-Financed Income (UDFI).  UBTI is one of the more complicated areas of tax law, but the basic guidelines are fairly straightforward when it comes to UBTI generated by an investment held within an IRA.

UBTI Defined

According to IRS Publication 598, UBTI  is “gross income derived by an organization from any unrelated trade or business regularly carried on by the exempt organization, less the deductions directly connected with carrying on the trade or business.” UBIT, or unrelated business taxable income is the tax that is paid on UBTI generated from a trade or business.

Publication 598 also states: “If an exempt organization regularly carries on a trade or business not substantially related to its exempt purpose, except that it provides funds to carry out that purpose, the organization is subject to tax on its income from that unrelated trade or business.”

There are exceptions, and most income generated by passive investments is exempt from paying UBIT, including income from dividends, annuities, royalties, interest from loans, and most rent generated from real estate.

Investments Generating UBTI

Investments most likely to generate UBTI include limited liability companies, limited partnerships, leveraged properties, and investments in active businesses.

In order for income to be subject to tax as UBTI the following must be true:

• The income is generated by a trade or business
• The trade or business activity is regularly carried on.
• The trade or business activity is not substantially related to the exempt status.

UBIT Tax Filing

At the end of the tax year investment sponsors will prepare and send out Schedule K-1. UBTI for the investment is shown under Section 20, Other Information. The amount of UBTI generated for the tax year is listed as Code V. If this figure exceeds $1,000, IRS Form 990-T would need to be filed to report and pay any UBIT due. Those required to complete Form 990-T will need to file for an Employer Identification Number (EIN), and can do so using Form SS-4.

If your IRA does owe UBIT, it is best to consult a tax preparer. They will ensure the registration and Tax Identification Number on the Schedule K-1 are correct, and prepare Form 990-T to submit to the IRA custodian.  Once complete, Form 990-T can be submitted to the self directed IRA custodian with authorization to file and instruction to pay the UBIT.

If you are considering an investment that may generate UBTI, your tax advisor should be consulted in advance. To learn more about Unrelated Business Taxable Income please view IRS Publication 598.  This publication also covers Unrelated Debt Financed Income, which will be discussed in a later post.

The IRS does not indicate what investments and transactions are allowable with IRA funds; instead they identify those that are prohibited. A Prohibited Transaction can bring into question the tax-deferred status of your IRA, potentially resulting in the disqualification of your account and substantial tax consequences. If it is determined that a Prohibited Transaction has occurred your IRA would be treated as a distribution as of the first day of the year in which the Prohibited Transaction took place.

What is a Prohibited Transaction?

Prohibited Transactions usually occur when the IRA engages in transactions with a disqualified person.

Who would be considered Disqualified Person?

• The IRA owner
• The spouse of the IRA owner
• Any lineal descendants and their spouses
• Any lineal ascendants and their spouses
• Investment advisors and managers
• Anyone providing services to the IRA such as a trustee or custodian
• Any entity in which any above person has a 50% or more interest

What Prohibited Transactions commonly occur?

• Borrowing money from your IRA.
• Selling property to your IRA.
• Receiving unreasonable compensation for managing an IRA asset, such as a rental property.
• Using your IRA as security for a loan.
• Buying property for personal use (present or future) with your IRA funds.

These rules were put into place for the IRS to ensure that all of the business conducted with the IRA is for the benefit of the IRA. Because the funds are intended for future retirement, actions that create an indirect benefit for the IRA owner could disqualify the IRA. Common examples of indirect benefits include:

1. Indirectly tapping funds for personal use

If two or more IRA owners loaned each other funds to avoid a Prohibited Transaction it would be considered an indirect benefit.  The parties may not be on the disqualified persons list, but since they are indirectly benefitting from the transaction, this action could potentially disqualify the IRA.

1. Sweat equity

If your IRA holds a property that needs improvements, providing the labor or having another disqualified person or their company provide the labor would be a prohibited transaction.  You would also not be able to use any personal tools or equipment to improve a property held by the IRA.

It may seem like there a lot of rules to remember on what you cannot do with your IRA. But keeping your IRA from engaging in Prohibited Transactions is the best way to protect your interest in your retirement.  You can easily avoid Prohibited Transactions by following these three simple rules when contemplating a transaction in your IRA.

First, make sure that anyone your IRA will be doing business list is not a disqualified person.

Second, avoid investing in collectibles, S-corp stock or life insurance contracts.

Third, look closely at the potential transaction with your tax advisor to decide if it would result in an indirect benefit to you or any other disqualified person.

Following these steps can help steer you away from potential prohibited transactions while still leaving the door open for numerous investments.

More information on self directed IRA investment options and prohibited transactions can be found in our IRA Resource Center.