Did you know that certain types of investments could subject your IRA income to a tax called Unrelated Business Income Tax, or UBIT? Congress and the IRS have determined that if your IRA account engages in ordinary income producing activities as opposed to passive income investments, the income from those activities should be taxed. In our first installment we talked about how to identify passive income and ordinary income as it pertains to investing in “flow-through” businesses. Today we are going to dive deeper into how UBIT could apply to the real estate investments conducted with your IRA. UBIT can incur taxes up to 37% if your investment income is equal to or exceeds $12,500 in a year, so it is not something that should be taken lightly.
How can I determine which real estate investments are exempt from UBIT?
Real property used to generate rental income is a form of passive income, steering those earnings clear of UBIT. UBIT comes into question when your real estate activities do not appear to be passive in nature. Fix-and Flips and vertical construction are real estate activities that could potentially trigger UBIT. The Facts-and-Circumstances test can be used as a rough guideline to analyze whether your real estate investments will be subject to UBIT. It can take one or a combination of these factors to trigger it.
Your perceived initial intent for the property plays a prominent role in whether or not the IRS will hone in on your real estate investment activity. Did you acquire the property with the intention of immediately selling it after? If so, this investment would catch the attention IRS. If you purchased a property with the purpose to earn rental income and then sold it, those capital gains would be protected from UBIT because of your initial intent.
Gauge the anticipated holding time of the property. Do you plan to hold it for less than a year and sell it? Anything held on a short-term basis would make it appear to be held as business inventory and not for a long-term, passive investment in your IRA. Fix-and-flips are usually completed in a short period of time in order to maximize gains. However, the number of flips is also taken into consideration with the holding time of the investments.
Number of Sales
The rule of thumb is that if you only complete one or two flips a year, your real estate activity is less likely to be perceived as an ordinary business activity. Anything greater than that, your real estate activity will more than likely fall under the scrutiny of the IRS and therefore be subject to UBIT.
Development, construction, or improvements
If you purchase raw land to construct and sell a fully developed home, it will most likely be considered an ordinary business activity and subject those earnings in your IRA to UBIT. However, you could purchase raw land only to perform preliminary development, such as permits and zoning approval, and then sell parcels of that land to developers who will then build homes. This activity is less likely to be subject to UBIT because it does not follow the full course of construction, marketing, and sale of the home like a residential developer would in the ordinary course of business. Of course, keep in mind the above factors as well in this type of real estate activity.
What are the tax implications of UBIT?
If your IRA earnings are subject to UBIT and are greater than $1,000, you must file with the IRS a 990-T tax return for the IRA. Your IRA will be responsible for paying the tax, you cannot pay for it out-of-pocket.
UBIT Tax Rate 2022
Is there a way to circumvent UBIT?
Yes, there is a way to avoid paying UBIT, but it does not avoid paying taxes on your profits entirely. With your IRA, you can establish a 100% owned C-corporation that your IRA exclusively invests in. With that IRA owned C-corporation, you can engage in your non-passive real estate activities and earn capital gains from the sale of those properties. That IRA owned C-corporation would then pay the 21% corporate tax on those gains and then distribute its income to the IRA account as a dividend exempt from UBIT.
How can I ensure that I understand the tax consequences of my IRA investments?
You should discuss any current or potential investments within your self-directed IRA with a tax professional. Tax professionals should be up to date on any regulations that would incur any sort of tax consequence, even one as obscure as UBIT.
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