In 2011, I published a six-part article series entitled “Investing Retirement Funds into Non-Traditional Assets using a Self-Directed IRA”. Because readers found that information to be useful as a “starting point” for learning about self-directed IRAs (perhaps because it was less “technical” than many other articles I have written), I have now revamped those articles and will post them periodically. Parts 1-3 can be found in prior posts on this blog. Part 4 is below…
When looking at the world of self-directed IRAs from the “10,000 foot level,” there are two categories of legal and tax concerns/problems that are the most critical when investing an IRA into “non-traditional” investments (e.g. real estate, privately-held businesses, hard-money lending, precious metals, tax liens, etc.). The first and most important problem to avoid is triggering the automatic invalidation of the IRA, or IRA-owned LLC (“IRA/LLC”), by having the structure enter into a “prohibited transaction” (for more on this topic, see Part 3 of article series). If a prohibited transaction occurs, many of the other issues become irrelevant because the IRA loses its tax-exempt status (i.e., the assets in the IRA become the personal assets of the IRA holder, significant tax consequences are triggered, and the IRA ceases to exist). However, assuming no prohibited transaction has occurred, the second legal/tax concern is whether the IRA’s (or IRA/LLC’s) investments are triggering current taxes at the IRA level. Unfortunately, this issue is often ignored due to the IRA account holder’s false assumption that income to an IRA (or IRA/LLC) is always exempt from tax. This is definitely not true. However, also keep in mind that incurring these current tax consequences is not necessary a bad thing, particularly if the overall investment is strong.
Active Business Income – UBTI:
Earnings within an IRA (or IRA/LLC) are generally exempt from tax. However, certain investments create taxable income called “unrelated business taxable income” (UBTI). UBTI is income from a trade or business regularly carried on by the IRA which is not substantially related to the exercise by the IRA of the IRA’s tax-exempt purpose. Interestingly, the tax code defines any active trade or business to be unrelated to the IRA’s purpose. However, there are statutory “modifications” that specifically exclude certain types of income out of UBTI, which is the reason why most “normal” IRAs (i.e., IRAs invested only into publicly-traded assets) never owe current tax. These “tax exempt” types of income include, but are not limited to:
- Dividends (e.g., paid to the IRA as a result of the IRA owning C Corporation stock; but note that payments from an IRA’s ownership in a partnership or LLC are not considered dividends);
- Interest (includes “points”);
- Rent from real property (assuming the property is not debt-financed);
- Sales proceeds from real property (assuming the property is not held as inventory or held in the ordinary course of the IRA’s business, e.g., flipping or development activity – and assuming the property is not debt-financed).
The basic idea behind the UBTI rules is that Congress did not intend for IRAs to compete with active businesses. Rather, an IRA is designed to be a “passive” investor. In an ideal world, the tax on UBTI puts IRAs on an equal playing field with other active businesses. However, because an IRA is taxed on UBTI at trust rates (which are very “condensed” – i.e., it doesn’t take very much income to get into the top tax bracket), an IRA can actually owe more tax than a similarly- situated individual who is operating the same exact business.
- IRA purchases a coffee shop and pays unrelated third-parties to operate the business (recall that no disqualified person can be financially involved or a prohibited transaction will occur). The income from the coffee shop will be treated as UBTI to the IRA and be subject to income tax at the IRA level.
- IRA purchases 10% of a “Project LLC” (or partnership) that invests into a “fix and flip” real estate strategy (or develops real estate from the ground up). Because the real estate is being held as inventory, income “flowing-through” to the IRA will be subject to UBTI. Further, because the IRA would be taxable on the UBTI whether the Project distributed profits back to the IRA or not, the IRA could run into a major liquidity problem (i.e., it could have a tax liability but no cash to pay the tax – note: the IRA account holder definitely cannot pay this tax on behalf of his or her IRA!).
- IRA makes a “loan” to an operating business structured as an LLC or partnership. Rather than only interest being paid back to the IRA, the business agrees to pay a percentage of its profits. The income associated with the “disguised equity” will likely be subject to UBTI because it does not constitute “interest”, but rather, the IRA is treated as being a fractional owner of the operating business.
Note: All of these examples apply equally regardless of whether the IRA invests directly or through an IRA-owned LLC structure. In other words, having an IRA purchase 100% of an LLC before making the investments above does not insult the IRA from UBTI.
Debt-Financed Income – UDFI:
Another way for an IRA’s income to be treated as UBTI and be currently taxable is under the “unrelated debt-financed income” (UDFI) rules. UDFI is triggered when the IRA receives (either directly or indirectly through a “flow-through” entity, like an LLC or a partnership) income from “debt-financed” property. For example, if an IRA purchases a piece of rental real estate using partial debt-financing (either seller financing or bank financing), UDFI will be triggered. However, because UDFI only applies to the percentage of income resulting from the debt-financed portion of the property, UDFI will generally result in less tax being owed than in the UBTI situation discuss above. This makes logical sense because the percentage of income resulting from the capital invested by the IRA (rather than the amount borrowed) should normally result in tax-exempt income. Also, the proceeds from the sale of the rental property will also be subject to UDFI, assuming that debt-financing still exists on the property within the 12 months prior to the sale. However, if the property has been held for longer than 12 months, long term capital gain tax rates (rather than trust tax rates) will apply.
- IRA purchases a piece of real estate using a 40% down payment and 60% seller financing. The property is then rented out long term to unrelated third-parties. Although the rental income would be completely exempt from current tax if the IRA purchased the property outright, in this situation, 60% of the rental income would be subject to the UDFI tax calculation. However, the tax impact will be reduced due to the fact that 60% of the expenses (e.g., interest, depreciation) from the property can be used to offset the UDFI income.
Note: Because a disqualified person (e.g., the IRA account holder) cannot be personally liable for debts of the IRA (or IRA/LLC), any debt involved in these examples must be “non-recourse”. The practical result of this requirement is that the IRA will likely have to put down at least 40% of the purchase price and pay interest at a slightly higher rate.
IRA Tax Filings:
If an IRA generates gross income subject to UBTI or UDFI of more than $1000 during the taxable year, the IRA must file Form 990-T (generally by April 15th) and pay a tax. This raises many issues to consider, including:
- In order to file the IRS Form 990-T, the IRA must be issued a federal tax ID number (“EIN”). This a very easy to get online.
- Self-directed IRA custodians often do not have the information necessary to file the 990-T because the IRA is invested into privately-held entities (e.g., LLC) and the investment paperwork related to those entities is sent directly to the IRA account holder. This problem is always present in situations where the IRA’s only investment is the 100% ownership of an LLC, which in turn makes all of the investments (facilitators like to advertise these structures as having “checkbook control”).
- The instructions for Form 990-T state that the “fiduciary” is responsible for filing the tax return. Because self-directed IRA custodians do everything in their power to not be considered a fiduciary, the IRA account holder is ultimately responsible for filing the Form 990-T. Therefore, it is vital for the IRA account holder to be properly educated on the UBTI/UDFI rules. Unfortunately, most facilitators and custodians do not give specific guidance in this area because they do not want to be viewed as giving legal and/or tax advice. The end result is a bit of a tax reporting “black hole” and the potential for large penalties and interest imposed by the IRS.
- An IRA subject to UBTI/UDFI must file on-going quarterly estimated tax payments in the same manner as a corporation. In other words, after the first 990-T is filed, the IRA must make payments every three months. Like many aspects of UBTI/UDFI and the related tax filings, this requirement is very easy to follow, as long as the IRA account holder has a competent CPA on board.
- Many accountants / CPAs are not very familiar with Form 990-T, which can result in the IRA account holder (and Manager of the IRA/LLC) scrambling to find a tax professional that can sort out these issues.
Despite all of these potential UBTI/UDFI issues, with appropriate up-front advice and back-end tax compliance support, all of these issues can be readily addressed – and, as stated above, the end-of-the-road investment returns can potentially be magnified, despite the IRA needing to file tax returns and/or pay current tax.
For additional reading material on the topic of UBTI/UDFI, see my article that appeared in the Journal of Accountancy, entitled “Self-directed IRAs: A tax compliance black hole“.