IRA Financial’s Adam Bergman discusses master limited partnerships (MLPs), private equity and hedge funds, and which is the best choice for your IRA.
There are several factors involved when deciding among MLPs, private equity and hedge funds. One of the biggest factors is UBTI, which stands for Unrelated Business Taxable Income. In this podcast, Mr. Bergman talks about how UBTI, among other things, affects these investments in your IRA. Finally, he will talk about whether or not you should invest in one of these vehicles with your IRA.
What is UBTI?
As defined on Investopedia:
Unrelated business taxable income (UBTI) is income regularly generated by a tax-exempt entity by means of taxable activities. This income is not related to the main function of the entity but is needed to generate a small portion of income.
An IRA is considered a tax-exempt entity. The most common type of UBTI comes when you use an IRA to borrow money for a real estate purchase. For example, if you have a rental property, the income it generates will be subject to UBTI if a loan was used to make the purchase. Currently, the UBTI tax rate sits at 37%.
While traditional stocks, mutual funds and ETFs are not subject to UBTI, MLPs, private equity and hedge funds are. As we just mentioned, the rate is high – much higher than the 21% corporate tax. Therefore, unless the returns far outweigh the taxes, it’s best to avoid the UBTI whenever possible.
What are MLPs, Private Equity and Hedge Funds?
These are three unique investments that you may have in your IRA. Let’s talk about what each of them are:
Master Limited Partnerships (MLP)
MLPs combine the benefits of a private partnership with a public traded company. MLPs grew in popularity in the oil and gas asset category because investors saw high returns with them. However, many failed to realize the pass-through aspect of the fund. This led to UBTI and all the investors of a particular partnership were hit with a huge tax bill. Sometimes you just don’t know if an MLP needs to file a 990-T to pay the tax.
Private Equity
Private Equity generally deals with limited liability corporations (LLC). Because of this, UBTI may come into play. When pass-through entities are invested in with an IRA, all the profits are funneled into the IRA. On the other hand, C Corporations, which most major companies are, are not subject to the UBTI tax. Therefore, the “C Corp Blocker” strategy is a tactic used to avoid the tax. So long as you are invested in bigger companies, you shouldn’t need to worry about UBTI. On the other hand, many venture capital funds are invested in startups, which may or may not be C corps.
Hedge Funds
A Hedge Fund is a pool of investments usually intended for accredited investors (those who exceed high income thresholds). They are a more aggressive type of investment that search for huge returns. The thing you need to worry about as an IRA investor is debt. Hedge funds are predicated on using debt for investment strategies. This debt could trigger the UBTI tax.
Should You Invest in MLPs, Private Equity and Hedge Funds with your IRA?
That’s depends exactly what the underlying asset of the fund is. Essentially, if the fund is invested in an LLC or partnership OR it uses debt inside the fund, it may not be worth it. However, if no debt is being used and the fund is primarily invested in larger corporations (C Corps), then you pay the 21% corporate tax rate instead of the 37% UBTI tax.
Approximately 95% of investors don’t need to worry about UBTI. If you invest in the stock market, there’s no need to concern yourself with the tax. If you use cash in your IRA for a real estate purchase (and don’t take out a loan), the UBTI tax is not triggered. Make sure you know what exactly you are investing in and be prepared for any tax consequences.
Get in Touch
Dealing with UBTI is a very confusing situation when investing in MLPs, private equity and hedge funds. Listen (or watch) the podcast for a better understanding. If you have any questions, please give us a call @ 800.472.0646.
Thanks for listening and be sure to check out our older podcasts on Soundcloud!
