UBIT Blocker Strategy
When a tax-exempt IRA or Solo 401(k) engages in a trade or business on a regular or repeated basis, this can create exposure to Unrelated Business Income Tax or UBIT.
With federal tax rates topping out at 37%, most IRA investors have stayed away from activities such as repeated house flipping that have exposure to UBIT.
The UBIT Blocker strategy is a way that those investors with the experience and opportunity in a UBIT exposed transaction type do not necessarily need to head in a different direction. The UBIT blocker does not eliminate taxation on such deals entirely, but can dramatically reduce the tax burden to the point where the deals become truly profitable to the IRA.
What is UBIT?
Unrelated Business Income Tax is the tax paid in certain circumstances when a tax-exempt entity like an IRA or 401(k) retirement plan is acting like a business and therefore competing with tax-paying businesses. When a tax-exempt receives income from investments in a trade or business activity that is regularly carried on, this creates Unrelated Business Taxable Income (UBTI), the cost of which is paid as UBIT.
The purpose of the tax is to level the playing field for tax-paying businesses and protect them from unfair competition stemming from tax-exempt entities.
When does UBIT Apply?
Common activities that generate UBTI and therefore a UBIT obligation for an IRA or 401(k) include active real estate transactions such as flipping, new construction for sale, or wholesaling. Investments into an operating business like a restaurant or retail store would also have UBIT exposure if the business is a pass-through for taxation such as a LLC or LLP. Venture capital deals can also create UBTI.
What is a UBIT Blocker
A UBIT blocker is an entity that elects corporate tax status. This be a sub-chapter C corporation or a LLC electing to be taxed as a C corporation. A Checkbook IRA or Solo 401(k) forms such an entity and places that entity between itself and the UBTI generating business activity. The entity will then pay corporate tax on the business activity it engages in. Any post-tax profits are then issued to the self-directed retirement plan as tax-sheltered dividends. Since the corporate tax rate is now 21%, this strategy results in a potential 16% reduction in the taxes paid on the business activity. This can be a significant boost to the bottom line.
Example – House Flipping
Let’s take a look at how a UBIT blocker works in the case of flipping houses, which is an investment of choice for many self-directed retirement plan holders. In a property flip the property is viewed as inventory held for sale in the normal course of business – or a “dealer activity”. This is a UBTI generating activity if done repeatedly.
Qualifying expenses such as cost of rehab, holding cost like property taxes and insurance, and sales costs would then be deducted from the gross income. Let’s say the total deductible expenses were $66,000, including $50,000 of rehab & holding costs and 8% for realtor commission and closing costs at the time of sale. This leaves a net profit and net taxable amount of $34,000.
Following is an illustration of how taxes apply to this transaction when done directly by the retirement plan and therefore exposed to UBIT trust rates, and when placed inside of a UBIT blocker corporation.
|Item||In-Plan, UBIT Applies||UBIT Blocker|
|Purchase & Closing Costs||$100,000||$100,000|
|Rehab & Holding Costs||$50,000||$50,000|
|Sales Commission & Closing Costs||$16,000||$16,000|
|Tax Amount||-$10,996 (UBIT)||-$7,140 (Corporate Tax)|
|Effective Tax Rate||32%||21%|
|Net After-Tax Profit||$23,340||$26,860|
By moving the transaction into a UBIT blocker, the net return to the self-directed IRA is increased by $3,520.
The benefit of the blocker is magnified over multiple transactions or larger dollar values, as the effective tax rate in the UBIT scenario will rise but the tax rate for the blocker will remain at 21%.
|Item||In-Plan, UBIT Applies||UBIT Blocker|
|Tax Amount||-$36,126 (UBIT)||-$21,420 (Corporate Tax)|
|Effective Tax Rate||35%||21%|
|Net After-Tax Profit||$65,873||$80,580|
If you were to flip 3 such properties per year in your IRA or Solo 401(k), that is an additional $14,707 of income. The benefit of the Blocker strategy is clear.
Any strategy that involves an active trade or business activity increases the administrative complexity for your self-directed retirement plan. Passive strategies such as holding rental properties or acting as a private lender do not require any tax reporting inside your plan.
A UBTI generating activity in the plan, or the use of a UBIT blocker will mean that your CPA becomes part of your self-directed IRA team, and will need to file some kind of tax return on your IRA’s behalf.
Strategies as house flipping can be very profitable for your IRA and help you achieve your goals with respect to long term wealth building – even with the corresponding tax implications. If your investment plan involves regular engagement in UBTI exposed transactions, considering a UBIT blocker may make a lot of sense.