UBIT (Unrelated Business Income Tax) and Self Directed IRAs: Information Alternative Investors Should Know
Self Directed IRAs provide the opportunity to invest in a variety of alternative assets such as real estate, precious metals, and small businesses, within a tax-advantaged account. The profits on Self Directed IRA investments are generally tax deferred or tax free, due to the “passive” nature of the investments. However, if you invest a Self Directed IRA in an active business as defined by the IRS, then UBIT Tax may apply to the profits.
What is UBIT?
Unrelated Business Income Tax, or UBIT, applies to the profits of an active business owned by a tax-exempt entity such as a qualified retirement plan. For example, if an IRA invests in an unincorporated active business (such as a gas station, grocery store, etc.), the net income (profit) generated is subject to UBIT.
UBIT and UBTI are often used interchangeably.
- UBIT (Unrelated Business Income Tax) – the tax owed based on the unrelated business income received by the tax-exempt account or entity.
- UBTI (Unrelated Business Taxable Income) – the type of income that is taxable.
Congress created UBIT to even out the competition between not-for-profit and for-profit organizations who operated the same type of business. Without UBIT, not-for-profit organizations had the unfair advantage of not having to pay the income taxes that for-profit organizations were subject to, allowing them to charge less for the same products and services.
Do Self Directed IRAs have to pay UBIT?
Most alternative assets in Self Directed IRAs never have to pay UBIT because the investments are passive in nature and tax-deferred (or tax-free within a Roth IRA). However, the following are scenarios when UBIT tax does apply:
The first is when a tax-exempt organization or entity, such as a non-profit organization or IRA/Solo 401(k), invests in an unincorporated operating business (such as an LLC that sells goods or services). The income that flows from the LLC to the IRA is ordinary income and, therefore, is subject to UBIT.
UBIT also applies to an IRA that uses debt to buy an investment, such as a loan on a real estate property. The income attributable to the debt, known as Unrelated Debt Financed Income (UDFI), is subject to UBIT.
When does UBIT apply?
Here is a break-down of common IRA investment incomes that require or are exempt from UBIT.
|Table 1: IRA Investment Income and UBIT|
|Income Type||Require UBIT||Exempt from UBIT|
|Dividend Income from a C-corporation (most publicly traded companies)||X|
|Royalty Income (income from intangible property rights)||X|
|Capital Gains (from the sale or exchange of property in the long-term)||X|
|Income generated from unrelated business activities||X|
|Income generated from an unincorporated active business (e.g. sale of goods/services)||X|
Does UBIT apply to my Real Estate Investment?
UBIT applies to real estate investments that are either debt-financed or undergo a short-term flip.
Ask these questions to see if UBIT applies to your Real Estate IRA Investment:
- Objective: Did you purchase the property to serve as a long-term investment or to be flipped and sold immediately?
- Time Frame: Did you hold the property for over a year? The longer the property is held, the more likely it is to be deemed held for investment and does not cause UBTI.
- Property Improvements: Did you purchase, develop, and sell the property? The less work done on the property, the more likely it is held for investment purposes.
- Debt-Financed: Did you use a loan to help purchase your property? If yes, the percentage of debt-financed property is subject to UBIT.
- For example, a property is purchased with 50% IRA funds and 50% through a loan. The amount subject to UBIT would be 50% of the net income earned from the property (through rental income or capital gains), after subtracting the first $1,000 and any deductions (expenses, tax, depreciation, etc.).
What Investment Choices Do I Have?
UBIT should not necessarily deter you from investing your Self Directed IRA in alternative assets. Many investors miss out on profitable opportunities because they are unfamiliar with UBIT. Investing in alternative assets, rather than traditional investments, with a Self Directed IRA creates a diversified portfolio and opportunity to increase IRA funds. There are also tax write-offs, such as depreciation, that limit the amount of UBIT owed.
How to File for UBIT
To report and pay UBIT, the IRA must file IRS Form 990-T by April 15. If the annual gross UBIT income exceeds $1,000, the IRA must report and pay UBIT. UBIT is paid with IRA funds, not the IRA owner’s personal funds. Some states may have their own form for UBIT. Contact a financial advisor to see if it applies to your state.
How to Calculate UBIT
The amount of UBIT owed depends on the annual income received.
|Table 2: UBIT Tax Rate 2020|
|Annual Income||UBIT Tax Rate (2020)|
|$0 – $2,600||10%|
|$2,600 – $9,450||$260 + 24% of the excess over $2,600|
|$9,450 – $12,950||$1,904 + 35% of the excess over $9,450|
|Over $12,950||$3,129 + 37% of the excess over $12,950|
For example, assume a Self Directed IRA invested in a grocery store that is an LLC and received a K-1 for $50,000 of net taxable income for the LLC for that year.
To calculate the amount of UBIT tax, complete the following:
- Excess Amount: $37,050 ($50,000 minus $12,950).
- 37% on the remaining $37,050, which equals $13,708.50.
- The total tax due is $16,837.50 ($13,708.50 plus $3,129).
- The after-tax net amount the IRA would keep is $33,162.50 ($50,000 minus $16,837.50 in UBIT tax).
How to Avoid UBIT
There are two scenarios that may be used to avoid UBIT. Discuss your options with a financial planner.
- Blocker Corporations: Corporate tax rates are significantly less than UBIT tax rates. Because of this, an IRA may benefit by establishing a 100% owned C-corporation, that the IRA invests in, and receives ordinary income. In this case, a C-corporation is used to “block” UBIT tax from being owed by the IRA in exchange for a lesser corporate tax.
- For example, if an LLC reports $50,000 of net taxable income to a Self Directed Roth IRA, then the IRA would have to pay $16,837.50 in federal taxes, based on the UBIT tax. However, if the same ordinary income business paid $50,000 in profits to a C-corporation that was owned 100% by an IRA, the C-corporation would only pay $10,500 (based on the corporate tax rate of 21%).
- Offshore Corporations: Foreign corporations often have much lower corporate income tax rates than in the U.S. However, a foreign corporation blocker company is a very complex structure and should only be considered after adequate due diligence.
In all cases, self directed investors should contact a financial professional to understand the rules and taxes incurred by your investment. For more clarification, reach out to a Self Directed IRA specialist.