Last Updated on February 5, 2020
Self-Directed IRA Investors and the UBTI Tax
In almost every case, when you use retirement funds to make an investment, the income gains will be tax-deferred. In the case of a Roth IRA or Roth 401(k), it’s tax-free. Internal Revenue Code (IRC) Sections 408 and 512 exempt IRAs (individual retirement accounts) and 401(k) plans from taxation that come from passive types of income. This includes interest from notes or bonds, rent from real estate investments, and gains/losses from the sale of a capital asset, such as stock.
However, in a number of instances, a lesser known tax, the Unrelated Business Taxable Income tax, or UBTI, can be triggered when a retirement account invests in certain types of transactions. Three types of investment categories can trigger the UBTI tax. They involve a tax-exempt organization or a retirement account. Triggers can occur:
- When you use retirement funds in a securities transaction involving leverage (margin)
- Using retirement funds in a real estate transaction involving a non-recourse loan to buy real estate (an exemption exists for 401(k) plans under various circumstances)
- If you use retirement funds to invest in a business that was owned through an LLC (limited liability company) or other pass-through entity, such as a partnership
IRC Section 511 taxes UBTI at the trust tax rates, which is quite high. For 2018, the highest trust tax rate is 37%.
There are two ways to get around the Unrelated Business Taxable Income tax. If you’re using a non-recourse loan to invest in real estate, do the following:
- Use a 401(k) plan instead of an IRA
- The C Corporation Blocker Approach
The 401(k) Plan Advantage
Like the Self-Directed IRA structure, a 401(k) plan can offer participants the ability to use plan funds to make alternative asset investments. This includes tax liens, cryptocurrencies and real estate. All income and gains you generate from these investments generally flow into the 401(k) plan without tax.
A Self-Directed IRA uses non-recourse financing for a real estate transaction. Therefore, any income or gains from the investment will trigger a penalty tax. This penalty is the Unrelated Debt Financed Income (UDFI) tax. This is part of the UBTI family. UDFI is a type of UBTI which, if triggered, can subject the IRA (individual retirement account) to close to a 37% tax for 2018.
Now, what exactly is a non-recourse loan? A non-recourse loan is a loan that isn’t personally guaranteed by the borrower. However, it’s often secured by an asset, such as the underlying real estate. In the case of a real estate non-recourse loan default, the lender generally satisfies the outstanding loan amount by the real estate securing the loan.
Understanding the UBTI Tax Rules
When it comes to acquiring a loan for a real estate investment involving a retirement account, the prohibited transaction rules under IRC 4975 do not allow the retirement account holder to personally guarantee the loan. However, an IRA holder is permitted to use a non-recourse loan as a part of a real estate transaction involving a retirement account.
In other words, an individual retirement account holder who wants to use leverage to buy real estate with retirement funds, will need to know the UBTI tax rules. First, the loan will have to be non-recourse. Second, if an IRA is used, the tax implications of the UBTI tax should be considered. Alternatively, if you’re self-employed or an owner of a business, use a 401(k) plan. The 401(k) plan provides more tax advantages than an IRA. This is due to the UBTI exemption available for 401(k) plans pursuant to IRC 514(c)(9). A 401(k) plan instead of to a Self-Directed IRA to make a real estate transaction with leverage is far more tax advantages because of the limitation on the application of the UBTI tax rules.
C Corporation Blocker Approach
A strategy that’s growing in popularity among retirement account holders is the C corporation Blocker Approach. This is ideal if you’re an IRA holder seeking to make investments that can trigger the UBTI tax. This involves the use of a C Corporation blocker. With the C Corporation Blocker approach, a retirement account investor can establish a C Corporation which the retirement account owns.
The C Corporation then holds the investment or invests the funds into the underlying pass-through investment. The reason the use of a C Corporation blocks the application of the UBTI tax is because a C Corporation is treated as an entity that’s separate from its shareholders. That makes it subject to a corporate level of tax. In other words, think of a C corporation as a wall that blocks out the UBTI tax. Whereas, an LLC or partnership is more like a funnel since a pass-through entity does not have any entity level tax. That means all the business income will funnel through the owners. As you can see, it does not block the application of the UBTI tax.
Let’s assume you’re a Self-Directed IRA owner who wants to invest IRA funds into a real estate venture. This venture operates through an LLC that will use a non-recourse loan as part of the real estate transaction. Using a C Corporation blocker approach allows the Self-Directed IRA investor to limit the application of the UBTI tax. It also reduces reduce the maximum potential tax rate from 37% to 21%.
The Best Choice for Self-Directed IRA Investors
It’s wiser to structure the loan as an equity investment rather than a loan. An equity investment generates interest income that’s not subject to the UBTI tax. The profit you make from an investment using an active business operated by a pass-through entity (LLC) that also involves leverage will have some tax implications. However, a C Corporation Blocker approach can be a very useful way to block the application of the UBTI tax and reduce the potential tax rate. The tax rate goes from 35% to the maximum C Corporation tax rate of 21%.
Using a Self-Directed IRA to buy real estate continues to grow in popularity. However, if you’re a retirement account holder who wants to use your retirement funds to invest in real estate, always be mindful of the application of the UBTI tax rules. It’s important to consult with a tax professional for further guidance.
Questions? Contact IRA Financial Group. Speak directly to a Self-Directed IRA specialist about Self-Directed investments, UBTI taxes and the establishment of a C corp.