How is UBTI generated?
Many CPAs are unfamiliar with the idea that normally tax-exempt retirement accounts, such as IRAs, may still be subject to taxation. In fact, during the course of business UBIT Professional has found many CPAs or financial professionals are incorrectly directing their clients that no tax is owed on their IRA investments. In certain circumstances, Unrelated Business Income Tax (UBIT), will apply to the tax-exempt account and may need to file the Form 990-T with any applicable supporting documents related to your clients’ situation.
For your clients who own assets in an IRA that have been debt financed or invest in certain entities like LLCs or LPs, they may produce unrelated business taxable income (UBTI), thereby incurring unrelated business income tax (UBIT) pursuant to IRC Sections 511-514.
According to the IRS, the purpose of an IRA is to provide retirement funds for the IRA owner. Any investment activity that is considered unrelated to the account’s tax-exempt status may be subject to UBIT.
Unrelated Business Taxable Income applies if ALL of the following are true:
- Income is derived from “trade or business” activity (i.e., sale of goods and services).
- Business activity is not substantially related to exempt status, which is providing retirement income for the IRA owner. Generally any business carried on by an IRA is unrelated to it’s purpose.
- Business is regularly carried on by the organization for the production of income.
- There is a special rule for trade or business regularly carried on by a partnership of which the exempt organization is a member. Refer to IRC Section 512(c) and Reg. § 1.512(c)-1
Generally, IRA investments that generate UBTI include investments in entities such as limited partnerships or limited liability companies, and any investment that leverages debt financing and/or is involved in an unrelated business.
Most passive investment income — including interest, dividends, royalties, and certain rent — is exempt from UBIT.
It has been determined by the IRS that any investment that generates unrelated business taxable income/unrelated debt financed income is subject to UBIT in direct proportion to the amount of UBTI/UDFI that is produced.
IRS Code Levels the Playing Field but UBIT Can Come Out Ahead
The Internal Revenue Code, Sections 511-514, imposes the tax on the business income of certain tax-exempt organizations, in this case IRAs, in order to level the playing field with other taxable entities.
This impacts client IRAs that invest in entities such as LLCs or LPs. For example if IRA funds are used to purchase or fund a convenience store or real estate company, this would be considered a business operation unrelated to the primary purpose of the IRA. The income will then be taxed at the trust tax rate as Unrelated Business Income Tax (UBIT).
Running the numbers for specific investment scenarios both inside and outside of the IRA or other tax-exempt vehicle can provide more accurate decision making tools for your clients.
Guidance Using Debt-Financing in an IRA
When clients are interested in real estate investing, financing is often a major part of the conversation. While UBIT may become part of the investment consideration, there are often substantial benefits to real estate investing with debt financing, despite the generation of UBTI.
For example, if the IRA investment earned $50,000 in gross income on a 25% debt-financed property, $12,500 would be subject to UBIT. From this starting point, allowable deductions, expenses directly related to the property, and depreciation are taken. If, for example, these expenses and deductions total $5,000 (after the 25% allocation), there would be $7,500 of unrelated business taxable income, before the specific deduction.
After the specific deduction of $1,000, the remaining unrelated business taxable income of $6,500 would then be subject to UBIT. Applying the trust tax rate applicable as referenced in 2014 Tax Rate Schedule for Trusts/Unrelated Business Income Tax, the total tax owed would only be $1,396 on a $50,000 profit. (For a detailed example of a proforma analysis of debt financed real estate, please see the Diversifying a Real Estate Portfolio Using Debt Leveraging page.)
How does this compare to the scenario where the real estate investment was made with discretionary funds? If the real estate investment were made outside of the IRA, the taxable income would be 100% of gross income earned on the entire $50,000 profit, minus applicable expenses and depreciation. If, for example, the net income was $30,000, income taxes would be owed at the applicable tax bracket of the investor. This tax could range anywhere from 10% to 39.6% ($3,000-$11,880) depending on the client’s filing status and income bracket.
Additional Guidelines When Using Debt-Financing
Advisors and tax professionals are showing an increased interest in familiarizing themselves with the tax reporting requirements of investing IRA funds in debt leveraged real estate. This interest is triggered by the growing interest and use by clients across the country. The combination of IRA funds and the use of debt instruments create a unique reporting requirement, but not one that can’t be decoded.
The debt-financed real estate held by your client’s IRA could be subject to UBIT if the property is producing rental income and/or has been sold in the current tax year. Clients that may have sold debt-financed property and have realized a short-term or long-term capital gain from the sale may be required to make an estimated payment on the tax due to avoid penalty and interest.
Whenever debt is used by a tax-deferred or tax-exempt entity (with some exceptions), tax is applied to the portion of the gain that is debt-financed. This income is called unrelated debt financed income or UDFI. Taxes are calculated and reported on IRS Form 990-T.
If debt-financed property and/or Schedule K-1 income has generated less than $1,000 of total combined taxable income, there is no requirement to file the Form 990-T for the current tax year unless the client wishes to carry-forward a NOL to offset possible future gains.
IRAs that receive income equal to the current $1,000 specific deduction or greater must file Form 990-T with the Internal Revenue Service on or before the April 15 deadline the following year. Form 990-T payments must be made from the IRA’s assets, and typically custodians need to receive direction to pay these taxes at least 10 days before the due date.
See IRS Publication 598 for additional rules for debt-financed property and income tax and UBIT generally.
Investors should consult professionals who are familiar with the IRS rules related to unrelated debt financing and unrelated business income tax. As a professional yourself, it is important to understand the time it takes to stay on top of UBIT preparation and filing. The IRS estimates that it will take over 100 hours per year to do so. According to the IRS Instructions for the IRS Form 990-T, it is estimated that it will take up to:
- 67 hours, 12 minutes for Recordkeeping
- 27 hours, 10 minutes to learn about the law and the form
- 43 hours, 25 minutes to prepare the form
- 4 hours, 1 minute to copy, assemble, and filing the form with the IRS
- 141 hours, 48 minutes annually to stay on top of UBIT annually for your clients
The IRS estimate does not factor the time it takes to learn, prepare, and file any applicable state forms currently required in 40 states.
UBIT Professional understands that for many CPAs and financial professionals this is too large of a time commitment for a tax that is rarely applied to your clients’ investments. Let us take this off your plate with a streamlined and done-for-you solution.