Unrelated Business Income Tax and Your Self-Directed Investments
Depending on the assets within your self-directed retirement plan, you may incur unrelated business income tax (UBIT) on certain investments. This is the tax assessed on profits from two types of alternative assets, ongoing operating businesses and real estate investments. Other terms you might hear related to these investments and tax are unrelated business taxable income (UBTI) and unrelated debt financed income (UDFI).
The tax is levied on profits from the debt-leveraged portion of the property’s net income or on an operating business within the tax-advantaged account. Just as with all income and expenses related to the self-directed investments, the tax is paid by the IRA/plan (not the account holder).
Unrelated business income tax is triggered in a couple of ways related to retirement accounts:
- Business profits -- A self-directed IRA or 401K has invested in a business (restaurant, salon, retail store, etc.) which generates profits. If the business has not paid business tax on those profits before distributing them to the retirement account, a tax is levied on the profits at trust rates. If tax is paid at the company level before profits are paid to the retirement plan, there is no UBIT. The income must derive from the operation of an active trade or business.
- Real estate profits -- Investments made with a non-recourse mortgage loan may trigger UBIT on profits from the debt-financed portion of the investment property. This comes into play if the IRA-owned property is sold while a percentage of ownership is debt financed. It also applies to any rental income sent back to the retirement plan if there is profit and debt financing. Expenses may be used to offset this as well. Expenses on the real estate investment can be used to minimize the profit calculation on the debt leveraged percentage of the property.
Other sources of income that could subject a self-directed IRA to UBIT are business income generated via a pass-through entity (such as an LLC or partnership) or using margin on a stock purchase.
Calculating Your UBIT rate
In general, the unrelated business income tax rate follows the IRS “trust rates” schedule. There is one exception related to real estate assets: the percentage of profits attributed to the outstanding loan percentage at the sale of the leveraged real estate (the debt-financed portion) is taxed at the long-term capital gains rate.
IRS Form 990-T is used to calculate what you owe. Depending on your particular financial situation, it could be a good idea to complete this form even if your self-directed investment won’t incur tax; Next Generation Trust Services recommends you consult with your trusted financial or tax advisor. Our company’s CFO, who is a certified public accountant, is available to handle your Form 990-T filing for an additional fee.