In general, when a Self-Directed IRA or Solo 401(k) plan makes an investment, the income and gains generated by the investment will not be subject to immediate taxation. However, in certain specific circumstances, the investment can trigger a tax known as the Unrelated Business Taxable Income tax (UBTI or UBIT).
- Real Estate remains the top investment for self-directed retirement investors
- UBTI can make a real estate investment tax-INefficient
- The Solo 401(k) plan has an exception for the dreaded UBTI tax
The UBTI Tax
One of the primary advantages of using a retirement plan to make investments is that all income and gains are generally not subject to tax. Most retirement account investments involve capital gains, interest, dividends, royalties, and rental real estate income (i.e. passive income). However, the following types of income could subject a retirement account to the UBTI tax:
- Using margin on a stock purchase
- Income from the operations of an active trade or business through a pass-through entity, such as an LLC
- Using a nonrecourse loan to purchase a property – Unrelated Debt Financed Income (UDFI)
This article will address the triggering of the UBTI as a result of a retirement plan triggering the application of the UDFI rules.
What is UDFI?
Internal Revenue Code (IRC) Section 514 requires debt-financed income to be included in unrelated business taxable income. It was enacted in 1969 essentially for the purpose of preventing charities from trading on their exempt purpose.
In the 1950s, many charitable foundations purchased commercial real estate under sale-leaseback arrangements, borrowing the necessary funds from lenders and leasing the property back to the seller for a period approximating the estimated economic life of the structure.
Under pre-1950 law, the charity received the rent tax-free and could therefore pay off the acquisition debt more rapidly than a taxable competitor. From the seller’s perspective, a sale-leaseback was similar to a mortgage, but, under the accounting practices prevailing at the time, the obligation to the lessor did not have to be recognized on the lessee’s balance sheet. If the sales price was less than its adjusted basis for the property, the seller claimed a loss deduction.
The Treasury argued before Congress that the charities, which ordinarily made only nominal down payments and borrowed the funds for the acquisition without recourse, were effectively trading on their tax exemptions. This ultimately led to the birth of IRC Section 514.
Retirement Account Subject to the UBTI Rules
Fair or not, retirement accounts, such as IRAs and 401(k) plans, like charities, are governed by Code Section 501 as an exempt organization and, thus, are subject to the UBTI tax rules as per Code Section 512. Code Section 514 specifically deals with instances when a tax-exempt organization, including a charity, IRA, or 401(k) plan generates UDFI as part of a transaction. For 2022, the top UBTI tax rate is 37%, which gets triggered at a low income threshold of approximately $15,000.
What is a Debt Financed Property?
Under IRC 514, if an exempt organization, such as a Solo 401(k), owns “debt-financed property,” some portion of each item of gross income from the property, and a like portion of all related deductions, are included in UBTI, whether the income is in the form of rent, interest, gain on disposition of the property, or some other character. Property is debt-financed if it is held for the production of income, its use is not substantially related to the organization’s exempt purposes, and there is acquisition indebtedness with respect to the property. The term “acquisition indebtedness” generally includes “any liability incurred before, contemporaneously with, or after the acquisition or improvement of the property if it arose because of the acquisition or improvement or if the need for the indebtedness was foreseeable at the time of the acquisition or improvement.”
What is Acquisition Indebtedness?
Section 514(c)(1) provides that the “acquisition indebtedness” with respect to any debt-financed property is the unpaid amount of (1) debt incurred to acquire or improve the property, (2) debt incurred at an earlier time if it would not have been incurred but for the acquisition or improvement, and (3) debt incurred thereafter if it would not have been incurred but for the acquisition or improvement and if it was reasonably foreseeable at the time of the acquisition or improvement.
Exemption for 401(k) Plans
IRC Section 514(c)(9) allows a few types of exempt organizations to make debt-financed investments in real property without becoming taxable under 514. Generally, indebtedness incurred by a qualified organization in acquiring or improving real property is not acquisition indebtedness for purposes of the UBTI tax rules if the transaction satisfies a list of requirements:
- The price paid by the organization for the property or improvement must be fixed when the property is acquired or the improvement is completed,
- Neither the amount nor the due date of any payment under the indebtedness can be contingent on the revenue, income, or profits from the property,
- The property may not be leased to the person who sold the property to the organization or to any person related to the seller,
- If the organization is a qualified pension, profit sharing, or stock bonus trust, the property may not be purchased from or leased to the employer of any of the employees covered by the trust or any one of several persons related to the employer,
- Financing for the property may not be received from the person who sold the property to the organization, a person related to the seller,
- The property must usually be owned directly by the qualified organization, except that an interest in a partnership or other pass-through entity qualifies if all of the partners or other owners are qualified organizations and each partner or other owner is allocated the same distributive share of every item of partnership income, deduction, and credit.
In sum, if a Solo 401(k) plan acquires real estate directly or via an LLC, and a nonrecourse loan is acquired as part of the transaction, Code Section 514(c)(9) would not treat the income as acquisition indebtedness so long as all provisions of the section are satisfied. It’s important to note that the exemption does not apply to IRAs.
Code Section 514(c)(9) was enacted in 1980 after IRAs were established. However, there is no good reason why the exemption under Code Section 514(c)(9) does not apply to IRAs other than Congress wished to provide 401(k) plans, more specifically large pension funds, greater investment options.
Code Section 514(c)(9) provides a Solo 401(k) plan with an enormous tax advantage over a Self-Directed IRA who seeks to invest in real estate that involve real estate acquisition indebtedness. Gaining the opportunity to leverage a real estate investment, without triggering the UBTI tax, provides real estate investors with additional incentive to go Solo.
Of course, one needs to be eligible to establish a Solo 401(k) in the first place. However, if you do meet those criteria, the choice is simple for real estate investors.