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.

A non-recourse loan is one in which the owner of the IRA is not personally held liable. If the loan goes into default the lender may take possession of the property, but it would be the only eligible asset that they would be able to pursue.

Few companies offer IRA lending, and the requirements for a loan to an IRA are very different than personal loans. Here are a few points to consider if you are thinking about financing a property with your IRA:

1)      A minimum of 30% down is needed, with some lenders requiring 40%.

2)      The property appraisal and potential income will be the main points of consideration.

3)      Properties that are not move-in ready or needing only minor work or repairs may not qualify for funding by the lender.

4)      Most IRA lenders will require that a portion of the loan remain in the IRA account for any expenses that might come up.

5)      The IRA may need to pay unrelated business income tax (UBIT) on the leveraged portion of the real estate.

Self Directed IRA Services, Inc. does not recommend any individual investments, and as a self directed IRA custodian, we do not offer non-recourse loans. For more information on non-recourse loans in a self directed IRA you may view the FAQ and Fact Sheet provided by Matt Allen, Director of IRA Lending at www.IRALending.com

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.

Here are the basics to help you get started and understand how it works.

Find an IRA Custodian

Locate an IRA custodian, preferably a bank or trust company, which accepts real estate in a self directed IRA or real estate IRA. It’s best to use a custodian rather than an administrator. Administrators use the services of a third party to custody your IRA investments which creates an extra layer that can lead to problems. Custodians are regulated by a state or federal authority, while administrators are not subject to any regulatory oversight.

Likewise, if you use a facilitator or middleman to assist you in finding a property, make sure they either work with or recommend an IRA custodian.  Many new firms offering self directed IRAs and real estate IRAs have entered the market in recent years promoting the LLC-structured concept of “checkbook control” IRAs.  Under this scenario, the IRA owner has full control over the use of their IRA funds– something that seems to contradict the IRS rules and many IRA custodians consider a gray area. Even some regulators, including the SEC and FDIC, have recently become concerned with the checkbook control concept and fear it may mislead an investor into a prohibited transaction which could lead to disqualification of the IRA and result in taxes and possible penalties.

Funding the Purchase

Once you find the property you want to purchase, you can either use cash from your IRA to purchase the property outright, or you can locate a lender to finance the purchase.  If your purchase will be financed, the lender must use a non-recourse promissory note.  This limits the recourse the lender would have to only the underlying property (and not other IRA assets) in the event of default.  No other IRA assets or personal assets can be used to collateralize the loan. If your IRA purchase uses debt financing, you should be aware that this would generate Unrelated Business Taxable Income (UBTI) and discuss this with your tax professional.

Starting the Transaction

It is also important to remember that the purchase offer and contract must identify the named purchaser as your IRA custodian for benefit of your IRA account (i.e., Self Directed IRA Services, Inc., Custodian FBO John Doe IRA).  In addition, all funds, including the earnest or escrow deposit must be paid directly from the IRA rather than out of your personal pocketbook.  Also, a closing date should not be set until the IRA is established and funded with your custodian.

Spare Funds Needed

Keep in mind that all expenses related to owning, maintaining or improving the property owned within an IRA must be paid by the IRA. This includes maintenance, repairs, taxes, insurance and improvements, as well as any mortgage payments if debt-financed. The way this usually works is that once you receive a bill or invoice for the expense, you would sign it as approved and send it, along with payment instructions, to your IRA custodian. The custodian then issues the payment from your IRA.

Income-Producing Property

If the property generates any income through rental or lease of the property, the income must flow back into the IRA. So whether you have residential, commercial, raw land or vacation renters, any tenant of the property would need to write checks to the IRA rather than to you personally. Or, you may need to use a third party property manager to handle the process and remit the income to your IRA.  Your custodian will provide the specifics for how this should work.

Keep it Arms-Length

Now, let’s address the questions we hear most often—

• Can I use the property for a vacation home?
• Can I lease the property to my son/daughter to use for their business?
• Can my IRA buy a property that I/my parents currently own?

These questions fall under the rules about prohibited transactions and self dealing under Internal Revenue Code § 4975. A prohibited transaction most commonly results when your IRA engages in a transaction with a disqualified person, primarily:

• The IRA owner and their spouse,
• The IRA owner’s ancestors (parents and grandparents) or lineal descendants (children and grandchildren) and their spouses,
• Any entity in which the IRA owner has a combined ownership of 50% or more.

In general, you cannot have any direct use or benefit of the property owned within your IRA.  Likewise, you should not engage in a transaction with a family member.  This means your IRA cannot lease a property to a disqualified person, nor can it buy or sell a property from a disqualified person.  As a general rule, if you follow the guidelines set forth, your IRA transaction should be okay.

Selling the Property

The property can be sold at any time to an unrelated party and the proceeds from selling an IRA-owned property roll back into the IRA without facing capital-gains taxes.

You can then invest the proceeds in another property or any other asset within your IRA. When you eventually withdraw funds from the IRA, the profit would be taxed at ordinary income rates when withdrawn from a traditional IRA— or tax-free if in a Roth IRA.

Summary

Given the uncertainty in today’s mainstream investments, real estate is gaining a great deal of interest as an investment option in self directed IRAs. It’s easy to see why. After all, most people prefer to invest in what they know and understand.

Knowing the rules associated with owning property in your IRA is essential, so do your homework and consult with your tax advisor so they may cover the details relating to the investment you are considering.

Whether your retirement strategy is to retain properties or buy and sell for gain, real estate investing through your IRA can yield astonishing profits toward your potential retirement.

To learn more about holding real estate in a self directed IRA, see our Real Estate IRA Investing information.

What is the 2010 Roth IRA Conversion opportunity?

For the first time since the Roth IRA debuted in 1998, individuals with an Adjusted Gross Income (AGI) over $100,000 can convert all or part of their Traditional IRA into a Roth IRA. This means that higher wage earners now have the opportunity to convert their current tax-deferred retirement dollars to tax-free status upon retirement.  The conversion may be a good option for those who think they’ll be in a higher tax bracket when they withdraw, don’t see themselves withdrawing funds for at least 10 years, and can pay the taxes due from sources other than the IRA.

When do I pay taxes on the conversion?

You have the option to pay the tax in full in 2010 or to claim 50% of the conversion amount in 2011 and the remaining 50% in 2012 – but keep in mind that this special provision is only for those that convert in 2010.  For conversions after 2010, taxes would be paid in full for the year in which the IRA is converted.  If you decide to convert in 2010 and opt to split the taxes in 2011 and 2012, there are a couple of things you may want to keep in mind— the tax rate you pay would be determined based on your tax bracket for 2011 and 2012, and the current tax cuts are set to expire at the end of 2010.

Can I still contribute after the conversion?

That’s the part that did not change.  The phase out limits still apply when determining whether an individual is eligible to contribute to a Roth IRA for 2010.   Individuals may make a partial or full contribution (up to $5,000; $6,000 for individuals age 50 and over) to a Roth IRA as long as their AGI falls below or within the phase out range.  For single filers in 2010, the phase out limit is $105,000-120,000.  For those filing jointly in 2010, the phase out limit is $166,000-176,000.  Individuals above the limit are not eligible to make Roth IRA contributions.

What if I convert and later decide it wasn’t right for me?

Those who convert and then later change their mind can do a recharacterization. This allows the IRA owner to reverse the conversion completely and can be done until October 15^th of the calendar year after the year the conversion took place. So, if you decide to convert in 2010 you would have until October 15, 2011, to recharacterize.  IRA account holders are not allowed to reconvert back to a Roth IRA within the same tax year or within 30 days of a recharacterization.

Converting to a Roth IRA can get tricky, especially if you have multiple IRAs or only want to do a partial conversion.  That’s why it’s important to discuss this with a tax professional to make sure you fully understand what the tax implications would be for your specific situation.