UBIT in a Self-Directed IRA

An IRA is normally exempt from tax on its investment income. The exception is unrelated business taxable income (UBTI). When an IRA earns UBTI, it pays unrelated business income tax (UBIT), even inside a Roth IRA. Most IRA LLC investments never trigger it. Here is what does, how it is taxed, and how to plan around it.

Income that is normally exempt

IRC Section 512(b) excludes the passive income most IRA LLCs earn: interest on loans and notes, dividends, rents from real property, royalties, and gains from selling investment property. If your IRA LLC makes private loans or buys rental property with cash, that income is normally not UBTI.

What triggers UBTI

• Running an active business. Income from a trade or business regularly carried on by the IRA, or by an LLC or partnership taxed as a pass-through in which the IRA invests (for example, a restaurant, a retail store or an operating company).
• Buying property with debt. Income from property bought with a loan is unrelated debt-financed income (UDFI) in proportion to the debt. See IRA non-recourse loans.
• Dealer activity. Frequently buying and reselling property, such as regular house flipping, can be treated as a business rather than investing.
• Pass-through investments. Some master limited partnerships (MLPs) and private funds that operate businesses or use leverage pass UBTI to their IRA investors.

How UBIT is calculated and paid

UBTI is reduced by related deductions and a $1,000 specific deduction. When an IRA has $1,000 or more of gross UBTI for the year, the IRA must file IRS Form 990-T. The tax uses trust tax rates, which reach the top bracket at a much lower income than individual rates. The tax is paid from IRA funds, not your personal funds. The IRA is the taxpayer, so the custodian or IRA owner coordinates the filing with a tax preparer.

UBIT does not make an investment prohibited

UBIT is a tax, not a penalty. A UBTI-producing investment is allowed in an IRA. It is different from a prohibited transaction, which can disqualify the entire IRA. Paying some UBIT can still leave you better off than the alternatives. Run the numbers.

Ways investors plan around UBIT

• Favor passive income such as interest, rents and capital gains.
• Buy real estate with cash, or pay down acquisition debt over time.
• Hold an operating business through a C corporation (often called a blocker). The corporation pays corporate tax, and dividends to the IRA are excluded from UBTI.
• For leveraged real estate, consider a Solo 401(k). IRC Section 514(c)(9) generally exempts qualified plans from UDFI on real estate debt. IRAs do not get this exemption.