How to calculate Tax on Unrelated Debt Financed Income from IRA Investments
When a tax-exempt organization like an IRA or charity borrows money for a transaction on a nonrecourse basis, the IRA or charity must complete IRS Form 990-T and Schedule E and report the income, as the income is likely subject to tax. In general, a tax-exempt organization like a charity or IRA is permitted to borrow funds on a nonrecourse basis (a loan that is not personally guaranteed by the borrower), however, a prorate percentage of the income or gains associated with the nonrecourse loan will be considered “unrelated debt financed income” which will likely trigger the “unrelated business taxable income” tax. Note: A recourse loan, a loan that the IRA holder will be required to personally guarantee is not a permitted transaction and is treated as a prohibited transaction pursuant to Internal Revenue Code Section 4975 as the loan would require the IRA holder to personally guarantee the obligation of the IRA.
IRS Form 990-T, Schedule E applies to all organizations except sections 501(c)(7), (9), and (17) organizations. Hence, the Schedule E would apply to IRAs.
When debt-financed property is held for exempt purposes and other purposes, the IRA must allocate the basis, debt, income, and deductions among the purposes for which the property is held. It is important to remember to not include in Schedule E amounts allocated to exempt purposes. With respect to an IRA, income considered exempt is all passive categories income, such as interest, capital gains, rental income, royalties, dividends, and interest. Thus, the majority of transactions involving IRAs are not subject to tax and Schedule E reporting.
When completing the IRS Form 990-T, Schedule E, below please find instructions:
Column 1. Any property held to produce income is debt-financed property if at any time during the tax year there was acquisition indebtedness outstanding for the property. In other words, if at anytime during the year there was an outstanding loan on the property, the property would be considered debt-financed. When any property held for the production of income by an organization is disposed of at a gain during the tax year, and there was acquisition indebtedness outstanding for that property at any time during the 12-month period before the date of disposition, the property is debt-financed property. Securities purchased on margin are considered debt-financed property if the liability incurred in purchasing them remains outstanding.
Acquisition indebtedness is the outstanding amount of principal debt incurred by the organization to acquire or improve the property:
1. Before the property was acquired or improved, if the debt was incurred because of the acquisition or improvement of the property; or
2. After the property was acquired or improved, if the debt was incurred because of the acquisition or improvement, and the organization could reasonably foresee the need to incur the debt at the time the property was acquired or improved.
With certain exceptions, acquisition indebtedness does not include debt incurred by:
1. A qualified (section 401) trust in acquiring or improving real property. See section 514(c)(9).
2. A tax-exempt school (section 170(b)(1)(A)(ii)) and its affiliated support organizations (section 509(a)(3)) for indebtedness incurred after July 18, 1984
3. An organization described in section 501(c)(25) in tax years beginning after December 31, 1986.
4. An obligation, to the extent that it is insured by the Federal Housing Administration, to finance the purchase, rehabilitation, or construction of housing for low and moderate income persons, or indebtedness incurred by a small business investment company licensed after October 22, 2004, under the Small Business Investment Act of 1958 if such indebtedness is evidenced by a debenture issued by such company under section 303(a) of that Act, and held or guaranteed by the Small Business Administration (see section 514(c)(6)(B) for limitations).
5. A retirement income account described in section 403(b)(9) in acquiring or improving real property in tax years beginning on or after August 17, 2006.
Column 2. Income is not unrelated debt-financed income if it is otherwise included in unrelated business taxable income. For example, the IRA should not include income that is attributable to a business investment held through an LLC so that the income is not taxed twice..
Column 4. Average acquisition indebtedness for an IRA investment is for any tax year is the average amount of the outstanding principal debt during the part of the tax year the property is held by the IRA. To figure the average amount of acquisition debt, determine the amount of the outstanding principal debt on the first day of each calendar month during that part of the tax year that the IRA holds the property. You would then have to add these amounts together, and divide the result by the total number of months during the tax year that the IRA held the debt-financed property.
Column 5. The average adjusted basis for debt-financed property is the average of the adjusted basis of the property on the first and last days during the tax year that the IRA held the property. One would then need to determine the adjusted basis of property, using the rules under Internal Revenue Code Section 1011 (section contains rules on how to calculate the basis of a property taking into account income, losses, expenses, etc). The property’s basis would then need to be adjusted for the depreciation for all earlier tax years, whether or not the organization was exempt from tax for any of these years. Similarly, for tax years during which the IRA is subject to tax on unrelated business taxable income, the property’s basis must be adjusted by the entire amount of allowable depreciation, even though only a part of the deduction for depreciation is taken into account in figuring unrelated business taxable income.
If, however, no adjustments to the basis of property under section 1011 apply, the basis of the property would be the cost.
Column 7. The amount of income from debt-financed property included in unrelated trade or business income is figured by multiplying the property’s gross income by the percentage obtained from dividing the property’s average acquisition indebtedness for the tax year by the property’s average adjusted basis during the period it is held in the tax year. This percentage cannot be more than 100%.
Column 8. For each debt-financed property, deduct the same percentage (as determined above) of the total deductions that are directly connected to the income of the debt-financed property. However, if the debt-financed property is depreciable property, figure the depreciation deduction by the straight-line method only and enter the amount in column 3(a).
For each debt-financed property, attach statements showing separately a computation of the depreciation deduction (if any) reported in column 3(a) and a breakdown of the expenses included in column 3(b).
When a capital loss for the tax year may be carried back or carried over to another tax year, the amount to carry over or back is figured by using the percentage determined above. However, in the year to which the amounts are carried, do not apply the debt-basis percentage to determine the deduction for that year.
Example 1. An IRA, via a self-directed IRA LLC, owns a four-story building, and is subject to a nonrecourse loan. The building generates $10,000 of rental income. Expenses are $1,000 for depreciation and $5,000 for other expenses that relate to the entire building. The average acquisition indebtedness is $6,000, and the average adjusted basis is $10,000. Both apply to the entire building
To complete Schedule E for this example, describe the property in column 1. Enter $10,000 in column 2 (since the entire amount is for debt-financed property), $1000 and $5,000 in columns 3(a) and 3(b), respectively, $6,000 and $10,000 in columns 4 and 5, respectively, 60% in column 6, $6,000 in column 7, and $1,800 in column 8 (60% of $1,000 and $5000 of depreciation/expenses). Thus, the IRA holder would be subject to tax on $6,000 of unrelated business taxable income, $10,000 of income multiplied by 60% - amount of average acquisition indebtedness of debt financed property ($10,000) over average adjusted basis of average debt-financed income ($6,000).
Example 2. Assume the same facts as in Example 1, except the building is rented out as an unrelated trade or business for $20,000. To complete Schedule E for this example, enter $20,000 in column 2, $1,000 and $5,000 in columns 3(a) and 3(b), respectively (since the entire amount is for debt-financed property), $6,000 and $10,000 in columns 4 and 5 (since the entire amount is for debt-financed property), 60% in column 6, $12,000 in column 7, and $3,600 in column 8. Thus, the he IRA holder would be subject to tax on $12,000 of unrelated business taxable income, $20,000 of income multiplied by 60% - amount of average acquisition indebtedness of debt financed property ($10,000) over average adjusted basis of average debt-financed income ($6,000).
What is the Unrelated Business Taxable Income Tax Rate?
Internal Revenue Code Section 511 taxes “unrelated business taxable income” (UBTI) at the rates applicable to corporations or trusts, depending on the organization's legal characteristics. Generally, UBTI is gross income from an organization's unrelated trades or businesses, less deductions for business expenses, losses, depreciation, and similar items directly connected therewith.
A self-directed IRA subject to UBTI is taxed at the trust tax rate because an IRA is considered a trust. For 2018, a Solo 401(k) Plan subject to UBTI is taxed at the following rates:
- $0 - $2,550 = 10% of taxable income
- $2,551 - $9,150 = $255 + 24% of the amount over $2,550
- $9,151 - $12,500 = $1,839 + 35% of the amount over $9,150
- $12,501 + = $3,011.50 + 37% of the amount over $12,500
To learn more about using nonrecourse leverage with a self-directed IRA, please contact an IRA tax expert at 800-472-0646.