The self-directed IRA (SDIRA) has increased in popularity over the last decade. Investors are using retirement funds to search beyond traditional investments like mutual funds, stocks and bonds. The goal of which is to obtain higher returns and allow for more control over their assets.
The SDIRA landscape is changing almost daily as a result of new financial products being introduced to the marketplace. SDIRAs (including Mega Backdoor Roths) can invest in almost any asset class except for S corporation stock, life insurance, and certain types of collectibles. In addition, there are specific “prohibited transactions” that account owners must stay away from.
But when examining the tax issues of SDIRAs, there can be substantial confusion. Even many CPAs have difficulty understanding the tax rules. They simply just don’t see them that often in their practices.
While it is true that an SDIRA can invest in almost anything, certain types of investments can and do trigger immediate tax issues. The two main tax issues for SDIRAs are:
- income that is generated from a trade or business that is regularly and directly or indirectly conducted; or
- income that is generated from debt-financed property.
These issues are commonly known as: (1) unrelated business income tax (UBIT); and (2) unrelated debt-financed income (UDFI).
Before we take a closer look at the tax issues relating to SDIRAs, let’s first examine what income is excluded from UBIT:
- Interest income. This would include payments made under loans, bonds, etc.
- Dividend income. This will typically include qualified dividends from a C corporation or dividends from a real estate investment trust.
- Royalty income. This generally includes income relating to intangible property and certain oil and gas activities. To be considered a royalty, the payment itself must relate to the use of a valuable right. However, royalties will not include any payments made associated with personal services performed.
- Rental income. Rents from real property are excluded in computing UBIT, although they may be subject to UDFI.
- Capital gains. Capital gains from the sale, exchange or disposition of property is exempt. However, this is not the case for property held primarily for sale to customers in the normal course of business. In addition, capital gains can be taxable in a transaction subject to UDFI.
A Closer Look at Unrelated Business Income Tax UBIT
UBIT is typically defined as the gross income derived from any unrelated trade or business regularly conducted by the exempt organization (the IRA in this case), less any deductions associated with carrying on the trade. The business itself must be “regularly carried on” in order for UBIT to be applicable. In most situations, UBIT occurs when an SDIRA owns a portion of an actual operating business (such as a service based business like a restaurant).
Upon initial review, UBIT may seem unfair. It was intended as a way to tax non-profit entities that engage in business activities that were unrelated to their original charitable purpose. UBIT provides a level playing field where non-profit entities are taxed on unrelated business income just like normal operating businesses are taxed. When retirement accounts were established by Congress decades ago, the rules were extended to further the level playing field between exempt and for-profit activities.
Unrelated Debt-Financed Income
UDFI is generally defined as any property held to produce income for which there is acquisition indebtedness at any time during the year. It also includes gains from the sale or disposition of such property. UDFI applies to tangible personal property and securities. But in most cases, it is seen when the SDIRA holds real estate.
UDFI is calculated as the percentage of average acquisition debt for a year divided by the property’s average adjusted basis for the year. For example, if your SDIRA acquires a rental house for $80,000, using a $20,000 down payment and a $60,000 loan, approximately 75% of the net income generated by the rental home would be subject to UDFI. In many cases, the tax consequences will be minimal because there are depreciation and other deductions that will offset rental income and limit any net income.
UBIT Tax Filing Requirements
So assuming an SDIRA has UBIT or UDFI, what are the tax filing requirements? First, a tax filing is only required if there is gross income of at least $1,000. If this threshold is not met, the SDIRA will still likely want to file a tax return. Even if there is no tax liability, it is a good idea to file a tax return so that the capital gains from the final sale of the real estate (which is taxable in part due to the debt financing) are offset by any carryover losses that have generated in prior years.
The SDIRA will file Form 990-T, Exempt Organization Business Income Tax Return, as applicable. Tax rates are steep because IRAs are taxed at trust rates as high as 39.6%. State taxes may also need to be considered.
Don’t also forget that UBIT would also be an issue for other qualified plans like cash balance plans, defined benefit plans, and pension equity plans. Take a look at the defined benefit plan rules.
Even though SDIRAs may invest in a variety of asset classes, investors must still understand any immediate and long-term tax consequences. UBIT and UDFI are especially important considerations when it comes to real estate investments. Make sure that you are educated and consider all tax consequences before you make any SDIRA investment.