This is an important topic because many people, especially those who have never had a self-directed ira, are unaware of the tax treatment for certain types of investments. UBIT was never an issue when investing in the set of mutual funds, or individual stocks, offered by a brokerage IRA account. Such investments simply earn dividend income or capital gains and are therefore passive investments. The corporations making these dividends to shareholders have already been taxed on their business profits prior to making dividends. Your IRA is allowed to escape the double taxation that other shareholders pay when receiving dividend income (although you will be paying ordinary income taxes on those profits when you later receive distributions from your IRA).
Active investments, on the other hand, receive their income as business profits, not as passive dividends. If you were to personally invest your own money as a sole proprietor or partner in an active trade or business, you would receive self-employment income or partnership distributions which are taxed to you personally. If your self-directed IRA makes the same investment and, for example, becomes a partner in an active business, it would theoretically avoid all taxation. The pass-through income would not be taxed at the business level or at the IRA level (at least not immediately and for Roth IRAs, never).
Naturally, the IRS had a real problem with this! Congress was concerned that this might provide an unfair advantage to exempt entities competing against private businesses that have to deal with taxes. Exempt entities were supposed to avoid taxation only on the activities related to their charitable function, not on unrelated side businesses that could generate additional tax-free revenues for the entity. To remedy the difference, IRC §§ 512-513 were enacted to require exempt entities, including your self-directed IRA, to pay a tax on the earnings received from any unrelated active (pass-through) businesses. This tax is known as the Unrelated Business Income Tax (UBIT). It is taxed at the same rate as trusts, which have the same brackets as individuals. However, it should be noted that trusts reach the maximum bracket much quicker (at a much lower income level) than do individuals or corporations. There also could be UBIT incurred at the state level and state law might not provide the same passive investment exemptions to UBIT that federal tax law provides so you should consult your tax advisor about your state tax issues.
Any active trade or business is, by definition, unrelated to the function of a retirement account so all retirement accounts would normally pay this tax when they invest in any trade or business.
Fortunately, there are a few exceptions to UBIT for your Self Directed IRA. It can avoid federal UBIT if its investment income comes from these passive sources:
- dividends (from C corporation shares);
- royalties (special rules apply to royalties from mineral interests);
- interest from passive loans
- rents from real estate, and any related rent from a small amount of personal property (defined as 10% or less of the total rental income);
- capital gains/losses on the sale or exchange of unleveraged equity interests in a business (whether a passive investment in stock or an active investment in a pass-through entity);
- gains/losses from the lapse or termination of options to buy/sell securities or real estate; and
- gains/losses from the forfeiture of good-faith deposits for the purchase, sale or lease of real estate in connection with the entity’s investment activities.
Note that certain rental income is still subject to UBIT, including:
- if rent is tied to the income of the tenant (such as with some shopping centers that charge a flat rate plus a percentage of sales)
- hotel rooms
- boarding houses
- tourist camps
- storage or warehouse space
- certain parking lot income
Many self-directed ira account holders will be satisfied with having the option to invest in real estate, precious metals, or similar passive investments and earn a better-than-the-stock-market rate of return. Such accounts are unlikely to generate UBIT. However, if you are interested in “rehabbing/flipping properties” or developing raw land, then this would likely constitute the running of an active business by your self-directed IRA and the net profits (above $1,000) would be subject to UBIT. Also, if your IRA is a partner in an active (pass-through) business venture, the net income generated (above $1,000) will be subject to UBIT. The only way to avoid paying UBIT is to limit your account to the passive investments described above.
Having said all this, paying UBIT is not the end of the world! There might very well be a potential investment that provides a substantial after-tax return on investment.
For example, which investment would you prefer?
(1) a mutual fund, which does not incur UBIT, and provides an untaxed 10% return
– OR –
(2) a real estate investment business (rehabbing/flipping properties), which incurs UBIT, but still provides an after-tax return of 25%
It’s easy to see that having to pay UBIT, by itself, should not be a deal killer. You can run the numbers and determine for yourself which opportunities have the best net returns. The thought of your self-directed ira paying any taxes is troubling to some but being able to stash away a large amount of funds and to help those funds grow at a higher rate than what the stock market provides is why self-directed IRAs are becoming so popular. You may have expertise in certain activities or industries and can determine which investments might be able to provide the best profits. The potentially substantial growth of your IRA may be well worth paying UBIT when necessary. Be sure to ask your advisor about state tax issues as well.
This brief discussion of prohibited transactions and UBIT/UDFI is not intended to be relied upon as legal or tax advice. It is very general information and is designed only to make you aware of some issues you might not have thought of and may need to discuss with your advisors. These rules can be very complex. Some of the rules have exceptions (and even exceptions to the exceptions!) and rules can and do change periodically. You must consult with your own independent legal and tax advisors to verify the accuracy of this information and determine the best course of action for your investment objectives and strategies.