For most Self-Directed IRA investors, the term, Unrelated Business Taxable Income, also known as UBTI, is not something that they would have to concern themselves with. Most Self-Directed IRA investments involve passive forms of income, such as capital gains, real estate rental income, dividends, interest, or royalties, which would not be subject to the UBTI tax. However, for IRA owners investing in assets involving leverage, margin, or pass-through businesses, the potential financial impact of the UBTI tax must be considered.
This article will describe the UBTI tax, it’s potential impact on certain Self-Directed IRA investments, as well as how to identify it on IRS Form K-1.
- Certain Self-Directed IRA investments may be subject to the UBTI Tax
- The K-1 form may help identify when you owe UBTI
- It’s important to understand when your investment may be subject to the tax
What is the UBTI Tax?
A number of specific IRA investment could trigger the UBTI tax. In general, the UBTI tax is triggered in three types of investment categories involving a Self-Directed IRA:
- Using margin to buy stocks or securities
- Using a nonrecourse loan to buy real estate
- Investing in an active trade or business operated through a pass-through entity.
The UBTI tax follows the trust tax rates, which is quite high; in 2022, the highest trust tax rate is 37%.
UBTI Impact on Self-Directed IRA Investments
One of the biggest advantages of using a Self-Directed IRA to make an investment is the tax benefit of not paying tax on any IRA income or gains. This is known as tax-deferral (or tax-free growth in the case of a Roth IRA).
The UBTI tax can turn a very tax-efficient investment into something that is quite the opposite. Turning an investment into a taxable transaction is not ideal, and could prove economically harmful to the IRA.
Identifying the Tax in a Self-Directed IRA Investment
One of the most difficult aspects of using a Self-Directed IRA to engage in a transaction that could potentially trigger the UBTI tax is how to determine if that tax has been triggered and if so, what the amount is.
If one is using a Self-Directed IRA to make a direct investment that triggers UBTI, such as using a nonrecourse loan to buy real estate, calculating the UBTI is possible. This is because the IRA owner would have access to all the required information, including the amount of debt, sum or depreciation, and other related expenses.
For example, if a Self-Directed IRA bought a rental property using $100,000 of IRA funds and borrowing $100,000 from a nonrecourse lender, the IRA owner would have the ability to calculate the pro rata share of all real estate-related expenses in order to arrive at the amount subject to the UBTI tax.
However, in the case where the IRA invests in a fund or private placement, it would receive a K-1 from the investment partnership identifying the IRA partner’s allocable share of partnership income or loss and the character of that income or loss.
Schedule K-1 is an IRS tax form issued annually for an investment in partnership interests. The main purpose of the Schedule K-1 is to report each partner’s share of the partnership’s earnings, losses, deductions, and credits.
In almost all cases, a Self-Directed IRA that is investing in a business or fund would receive a Schedule K-1 as part of the Form 1065 partnership return that the business or fund will file with the IRS. The K-1 will identify any income or loss of the partnership and the type of income generated by the partnership, such as business income, interest, and short- or long-term capital gains.
However, in many instances, the manager or general partner of the partnership will not identify the amount of the UBTI allocated to the Self-Directed IRA on the K-1. There is no particularly good reason why this is, since the identity of the investor as an IRA should be known.
Regardless, in many instances when the investor receives a Schedule K-1, the amount of UBTI is not identified, which makes reporting the UBTI on IRS Form 990-T and paying the UBTI tax quite difficult, if not impossible.
Reporting UBTI on the K-1
In the case of a Self-Directed IRA that invests in a business via a partnership, generally $1,000 or more of business income would mean that the IRA would be subject to the UBTI tax. Note – net business income of less than $1,000 would not requite the filing of IRS Form 990-T or the payment of any UBTI tax.
Whereas, if the Self-Directed IRA invested in a partnership that had debt or leverage, the identity of the UBTI tax would be more difficult. Generally, the manager of general partner would be required to report the amount of any UBTI using Code V in box 20. Otherwise, it would be nearly impossible for the IRA owner to know whether the investment triggered the UBTI tax.
This is the main reason why many investors do not report the UBTI tax to the IRS because they are not being made aware of the presence of the UBTI tax. Because Self-Directed IRA investors are often passive investors in private business- or private investment-type investments, it would be very difficult for the IRA owner to know whether the entity used any leverage that might trigger the UBTI tax. If the K-1 does not identify the UBTI tax in Box 20 using Code V, the investor would have little opportunity to know whether any UBTI tax is due.
This is especially true for Self-Directed IRA investors that have invested in an investment fund or even a private business via a pass-through entity that has used leverage. How would investor know if any leverage was used by the fund and, if so, how much leverage was used? An IRA that invests in a business could potentially uncover the amount of UBTI through the amount of income set forth in Box 1 – ordinary business income.
Having the ability to issue spot when a potential Self-Directed IRA investment could trigger the UBTI tax is important. For investors making direct investments in which they have control over the investment, such as a direct purchase of a house, identifying the potential impact of the UBTI is manageable. In situations where the investor makes a passive investment into a private placement or investment fund-type investment, the Schedule K-1 is essentially the only way to identify if the tax was triggered.
The problem is that some partnership managers or general partners do not identify the amount of the UBTI, either because they are not aware that an IRA is an investor or that the UBTI tax even exists. This is the primary reason why many Self-Directed IRA investors are not properly self-reporting the UBTI tax on Form 990-T.
It’s imperative to work with a professional who can help determine any UBTI tax owed from your investment. Failure to do so could lead to an even bigger headache.