Most of us think about IRA and 401(k) retirement plans as being completely tax-sheltered. So many investors are shocked when they learn that this isn’t entirely true.
Some types of investments made within an IRA can create a tax liability for the IRA.
Within the narrow scope of investing in common financial products, there are no tax implications for a tax-exempt retirement plan. This is the framework most of us are used to, and why the concept of taxes in an IRA is disconcerting.
With a self-directed IRA, you have the flexibility to invest much more broadly. This flexibility opens the possibility of certain transactions where taxation can apply inside of a normally tax-sheltered entity.
An IRA or 401(k) creates taxable income in two cases:
- When using debt-financing, and
- When engaging in a trade or business
The fact that an IRA transaction may have a tax cost doesn’t necessarily rule out an investment as a great way to grow your retirement savings. Many very profitable types of investing are taxable, but if the post-tax returns are better than average, your IRA can still come out ahead.
Misinformation About IRA Taxes
Not surprisingly, the fact that taxes can exist inside of an IRA creates all kinds of confusion.
The amount of bad information circulating on this topic is mind-boggling, and spans the spectrum from the unfounded fears of the misinformed to false assumptions and factual misstatements to shady strategies for tax avoidance.
But it doesn’t need to be this way. With a little bit of effort and expert guidance, you can obtain a solid understanding of the possibility of taxes inside your IRA, and strategize appropriately.
Understanding the industry language is the key to understanding this concept.
Where we see folks get the most confused is by information that uses the wrong terminology and mixes concepts. There are three key acronyms associated with taxes inside an IRA:
1. Unrelated Business Income Tax – UBIT
This is simply the name of the tax paid when a tax-exempt IRA engages in an activity that creates tax exposure.
UBIT is similar to “Income Tax”, in a personal sense. There are a lot of different types of activities that create income tax, with different rules in terms of applicability, deductions, etc.
The same is true with UBIT in the tax-exempt space.
UBIT is often the one and only word used to describe this whole field. That isn’t precise, and is a big cause of confusion for retirement investors.
2. Unrelated Business Taxable Income – UBTI
UBTI is a type of income generating activity that creates tax exposure.
When a tax-exempt entity engages in a trade or business activity on a regular or repeated basis, it’s deemed to be creating UBTI. Flipping houses is a common example of a dealer activity considered to be a trade or business in the real estate space.
After dealing with the income, exemption, and deduction logic of a tax return, the tax paid on UBTI will be in the form of UBIT.
3. Unrelated Debt-Financed Income – UDFI
UDFI is generated when a tax-exempt entity uses debt-financing. A common example would be an IRA using mortgage financing to acquire a rental property.
After dealing with the income, exemption, and deduction logic of a tax return, the tax paid on UDFI will be in the form of UBIT.
When we examine topics of taxation inside of an IRA, it’s important to focus on the type of income generating activity. Each activity has different applications and different implications for an investor.
There are, of course, a whole range of investment activities that an IRA can engage in without any tax implications.
For many investors, understanding where this line is drawn and staying on the non-taxable side of the line is the preferred approach. This can be the correct approach. Simple is good.
Passive, non-leveraged investments won’t be taxed. Passive investments include:
- Interest from note instruments
- Rent from real property
- The eventual sale of an asset that has been held over time to produce such passive income.
Investing in notes, whether directly as a lender or into a note fund is a very popular form of investing with a self-directed IRA. Interest is passive in nature, and not subject to taxation.
Many investors like to purchase rental properties using all cash with an IRA or Solo 401(k). Income from rental cash flow is passive, and therefore fully sheltered (as is any future gain on sale if the property appreciates over time).
Investing in a private company that operates as a subchapter C corporation will produce dividend income, which is also passive. This is much like investing in publicly-traded companies in the stock market.
Tax on Debt-Financed Investments – UDFI
Leverage is a powerful tool for investors.
If you can use $100,000 of your IRA to make a down payment on a $200,000 property, your IRA will make more money than if it simply purchased a $100,000 property using all cash — even after considering the costs of the borrowed money.
With a self-directed IRA, you can apply this classic investing principle and use leverage to accelerate the growth of your tax-sheltered retirement savings.
Let that sink in for a moment.
However, this power to use leverage introduces a small tax cost. The percentage of the income that the IRA receives as a result of the non-IRA money is considered to be UDFI and subject to taxation.
With a property that is 60% debt-financed, that means 60% of the gross income is taxable. The IRA then gets to apply the same 60% ratio of allowable deductions like depreciation, interest on the note, property taxes, etc. to reduce the amount of table income.
The end result is that a small portion of the overall income generated by the property becomes taxable, and the tax hit is generally not significant.
If you browse the internet for information on UDFI, however, you’ll frequently see incorrect statements indicating that if you use 60% debt-financing, 60% of your income is taxed at the maximum UBIT rate of 37%.
This simply isn’t true… but it would certainly be a disincentive to research the concept further if you took that bad information at face value.
A while back we performed an analysis on the use of a non-recourse mortgage to purchase a $200,000 rental property as compared to making an all cash purchase on a $100,000 property. Over a 5-year hold, the leveraged investment produced an additional $78,000 of return at a tax cost of $4,700.
If you were to say: “Taxes are going to cost me $4,700”, that sounds bad. Many investors might balk at that point.
When you look through the tax cost and see the significant $78,000 boost in overall return from the investment, it’s a no-brainer. Leverage wins!
We recently analyzed an IRA investment into a leveraged real estate syndication and found similar results. Tax on UDFI reduced annual returns by about .5% on average during the hold period.
Thanks to the use of leverage, the returns were above 14% even after the tax hit. A stable investment in real property producing 14% or better returns is a good thing.
The Solo 401(k) Exemption to UDFI
Tax on Unrelated Debt-Financed Income applies to both IRA and Solo 401(k) plans. A great thing for some real estate investors is that 401(k) plans have an exemption for debt-financed income where the debt is used for the acquisition of real property.
For investors looking to have their plan purchase a rental property using mortgage financing, or to participate as a limited partner in a leveraged multifamily real estate syndication, this exemption is a real benefit.
A 401(k) plan will get to keep 100% of the leveraged return without the cost of taxation. More importantly, the administrative burden of having your retirement plan file a separate tax return is eliminated.
For investors who qualify for a Solo 401(k), this exemption from UDFI is one of many reasons the Solo 401(k) can be a superior self-directed retirement plan format.
Tax on Trade or Business Activities – UBTI
With UDFI, we typically see a small tax cost in exchange for a significant benefit in overall investment return.
When a tax-exempt entity engages in a trade or business on a regular basis and therefore creates Unrelated Business Taxable Income, the tax implications may not be so trivial. Great care must be taken with evaluating UBTI generating investments.
The principal behind UBTI is to level the playing field and protect tax-paying businesses from unfair competition.
Common examples of activities that create UBTI include:
- Active real estate transactions such as flipping, wholesaling, or new construction for immediate sale.
- Venture capital and other forms of private equity investments with a direct equity stake in a pass-through entity such as a LLC or LLP. (Dividend income from a subchapter C corporation is passive).
- Any kind of dealer activity comprised of simply buying and reselling assets.
- Direct ownership in an operating business taxed as a pass-through.
UBTI is the net income produced by such activities after allowing for deduction of normal expenses. The trust tax rates that apply to an IRA or 401(k) rapidly scale up to 37% at income levels over $12,750. As such, the amount of UBIT paid can be significant.
When evaluating investments that create UBTI, there are a few key questions to consider.
What will the impact of UBIT be?
In some cases, with very profitable ventures, the net-after-tax returns can still be quite good and perhaps better than other investments your IRA may be participating in today.
Put another way, while an IRA may not be the most tax-efficient way to accomplish a certain type of deal – that deal may be better for the IRA than other options.
What type/portion of income from the investment will be UBTI generating?
UBTI applies to operating income, not to equity gain. In a true venture capital play where the prize is selling the IRA’s stake in the company for a higher price than what was paid originally, the fact that some of the operating income occurring between the purchase and sale is taxable may be inconsequential.
This is especially valid in a startup where income in initial years may be negative, providing write-offs for income in future years.
If the benefit of making the investment in a business is the ongoing operating income the business will produce, however, then UBTI will likely spoil the opportunity.
When an IRA or Solo 401(k) generates taxable income, the plan is the taxpayer and must file a separate return using IRS form 990-T.
UBIT has no intersection with your personal tax return. It’s your obligation as the IRA or 401(k) account holder to arrange for return preparation and filing.
It’s a best practice if you intend on investing in ways that will generate UDFI or UBTI that you meet with your licensed tax professional in advance. They will help you to properly gauge the tax implications of a planned strategy, and guide you with respect to the records they will need from you in order to prepare the tax return.
Not all tax professionals are familiar with the issues surrounding taxation in a retirement plan. Fortunately, these same tax matters apply to all tax-exempt entities such as religious organizations, hospitals, educational institutions, etc. Any tax provider familiar with these classes of entities should be able to assist you.
Hopefully we’ve helped clarify some of the basic principles surrounding taxation on UDFI and UBTI inside of a self-directed retirement plan.
The key takeaway for us has always been to look through the tax itself and evaluate the overall risk/reward of a given investment.
If an opportunity will be more secure and produce better income than non-taxed alternatives, it may be worth pursuing.
That said, if you have a choice between two investments that will produce similar returns, with one having UBIT exposure and the other not, the simplicity of the non-taxed opportunity may make that the better option.
IRS Publication 598 – Tax on Unrelated Business Income of Exempt Organizations
U.S. Code § 512 – Unrelated Business Taxable Income
U.S. Code § 514 – Unrelated Debt-Financed Income
IRS Form 990-T – Exempt Organization Business Income Tax Return