This article will provide answers to some of the questions you have surrounding unrelated business taxes; however, let’s start with a fun fact surrounding the IRS and taxes. Did you know that the IRS first began during the Civil War, and the tax code is over 700,000 pages long? More specifically, the UBIT law started in 1950 when Congress created an unrelated business income tax so that non-profits could not have tax advantages over taxable businesses that participate in the same activities.
What is an unrelated business? Examples of an unrelated business include advertising, sales of merchandise, ticket sales for entertainment events, memberships, and filming.
Unrelated business income tax applies if all the above are true. Examples of companies related to UBIT would include bars and restaurants, leasing office space, or advertising. UBIT applies to ordinary income received by an IRA and was first created as a way of taxing non-profit corporations that engage in private, for-profit activities unrelated to their charitable purposes. When retirement accounts were created, it was important to separate what income would be exempt from tax and what income should still be subject to taxation.
UBIT and Real Property. UBIT applies to the net profits that arise from the development of real property without any investment intent, for example a ‘fix and flip’ property. Real property investments should be held for one year or longer to be exempt from UBIT tax. Speaking with your CPA or tax advisor is the best option when determining how UBIT works in your specific investment situation.
UBIT and startup companies. You can loan money to a start up company in the form of a promissory note. These notes typically convert to equity shares after a certain time frame. You will need to be aware that if you do convert to ownership of the company and if that company is a ‘pass-through’ operating an ordinary income business, then the IRA may be subject to UBIT tax on the profits earned.
What are some exemptions to UBIT?
- Interest Income
- Dividend Income
- Royalty Income
- Rental Income
- Capital Gains
IRA’s that are invested into businesses that do not pay corporate taxes can be subject to UBIT. It is important to note that UBIT tax does not disqualify your IRA from investing.
Unrelated Business Income Tax (UBIT)
Even though the business can be recognized as tax-exempt, it may still qualify for UBIT. An exempt business that has more than $1,000 in gross income from an unrelated business must file IRS Form 990-T. You must pay an estimated tax if you expect your tax for the year to be $500 or more. Many modifications and exclusions apply. It is important to check the IRS website for exact exclusions to see if you qualify.
What is an exempt business type?
- Charitable Organizations
- Churches
- Religious Organizations
- Private Foundations
- Political Organizations
- Other Non-Profits
What does UBIT mean?
The definition of unrelated business taxable income [UBIT] is the income generated by a tax-exempt organization, listed above, that is not related to the organization's tax-exempt purpose. UBIT is in place to prevent tax-exempt businesses from unfairly competing with a for-profit business. This prevents the business from participating in activities unrelated to its tax-exempt purposes without paying taxes.
Unrelatable Taxable Business Income IRA
What is debt financing? Debt financing applies if your IRA owns an investment property and the property was purchased using a non-recourse loan. The IRA’s tax liability may differ annually depending on the investment performance and debt-to-equity ratio. Rental income, on the other hand, is not subject to UBIT; however, if the term of your rental contract includes additional services, those specific services can be subject to UBIT. Your rental income may still be excluded if you fall within the 85% rule. If you have purchased an investment property using your retirement account, and you decide that the IRA is now going to sell that investment property, any outstanding debt that you owe on that loan earns unrelated debt-financed income [UDFI] on the percentage of gains corresponding with the debt used to purchase the property initially.
What is UDFI? Unrelated Debt-Financed Income is a specific type of Unrelated Business Income that happens when an IRA uses debt to finance an investment and then, in turn, generates income from that investment. For example, a rental property held within your retirement account that you had purchased using a non-recourse loan, and that property either earns rental income or receives a profit when the IRA sells the property.
How do you calculate UDFI? In this example, we are going to use an investment property with debt financing. If 20% of the property is paid for and the other 80% remains financed, only the 80% would be subject to UDFI. You would need to subtract the total deductions and exemptions from the gross-related income, and that difference would be the total income that is subject to UDFI. The standard exemption of $1,000 is automatically subtracted from the unrelated business income. If a business has a net unrelated business income of $4,000, the taxable unrelated business income would be $3,000, and tax would then be calculated based on the taxable income of $3,000.
What is a non-recourse loan? A non-recourse loan, within a retirement account, protects the custodian and the owner's IRA by only allowing the lender, in the case of a default, to collect payment by taking possession of the physical collateral. The lender cannot go after the IRA, the IRA owner, or the custodian to retrieve payment. They cannot go after the borrowers’ personal assets or wages for the remaining balance owed. A non-recourse loan is standard and required if you hold the loan within the retirement account. Your retirement account will also be responsible for making the loan payments as noted in the promissory note.
What is the 85% rule? The 85% rule explains that if you use at least 85% of your building space for an exempt purpose, the entire rental income remains excluded, regardless of the debt financing behind it. If less than 85% of the space is being used for an exempt purpose, a specific percentage calculation comes into play. This calculation takes into consideration the average value of the property vs the average debt on the property.
What is UBTI in an IRA? If you receive income into your IRA and that investment generates income from a business that is unrelated to the purpose of the IRA, or if it involves debt financing, you may be subject to UBTI. Investments into Master Limited Partnerships, Limited Partnerships, Private Equity Partnerships, and Hedge Fund Partnerships all generate unrelated business taxable income. If your IRA directly owns and operates a business, such as a checkbook LLC, the profits from that LLC would be considered unrelated business taxable income. If the IRA has over $1,000 of gross UBTI, the IRA is required to file IRS Form 990-T and pay the taxes.
Who files the 990-T and pays the taxes? If the investment is held within your IRA, you, as the IRA owner, are responsible for filing a 990-T tax return for the IRA to the IRS. The IRA is responsible for paying the tax.
Avoiding UBIT
How do you avoid having to pay unrelated business income taxes within your self-directed IRA? You can avoid UBIT by investing in syndications and investment companies that purchase properties with cash and no debt. When you are making an investment in a company, more specifically with real estate, make sure to ask the investment sponsor if their properties are purchased using debt financing. This is not common and may be difficult to find these investment sponsors. You can also avoid having UBIT within your self-directed IRA if you invest in debt projects rather than equity investments. You can also avoid UBIT by investing in a C-Corp or a business that is operated through a ‘pass-through’ company. Your IRA will invest in a C-Corp, which will, in turn, invest in the operating business. This protects the IRA from unrelated business taxable income because the C-Corp will pay a corporate income tax before any of that income trickles down to the IRA as a dividend. These dividends are not subject to UBIT. Under certain conditions, your Solo 401k may also be exempt from UBIT if you are investing in real estate that is debt-financed. Consider investing in a partnership with other investors instead of using debt financing.
Conclusion
UBIT and UBTI are not scary! For more information regarding debt-financed properties and income tax, see IRS Publication 598. You should also consult with a tax professional or CPA for additional questions. If you think you have asked everything you need, ask more! There are rules affecting UBIT that vary by state, and a professional can provide insight into your specific situation and guide you through. The UBTI rules are broad, and multiple exemptions apply; a CPA who is familiar with retirement accounts and UBIT would be able to assist with determining if you are required to pay tax.
