Internal Revenue Code (IRC) Section 514 requires debt-financed income to be included in Unrelated Business Taxable Income, also known as UBIT or UBTI. For Self-Directed IRA or 401(k) investors seeking to use retirement funds to invest in real estate investment funds, the tax becomes a major investment hurdle. However, an exemption to the tax exists under IRC Section 514(c)(9) for 401(k) plans, but not IRAs. However, there are several rules surrounding the application of the rule for exempting income attributable to the use of debt financed income for 401(k) investors.
- UBIT is a tax that applies to certain retirement account investments
- UDFI, a type of UBIT, is the most common and occurs when using leverage in a real estate investment
- Internal Revenue Code Section 514(c)(9) offers a UBIT exemption for 401(k) plans
Why was IRC Section 514 Enacted?
In the years immediately following World War II, many charitable foundations purchased commercial real estate under sale-leaseback arrangements, borrowing the necessary funds from institutional 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 standpoint, 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. Congress responded in 1950 with the enactment of the statutory predecessor of § 514, which treated the rent under certain “business leases” as unrelated business income if the charity effected the acquisition with borrowed funds.
What is UBTI and UDFI?
Almost all retirement account investments generating passive income will not be subject to UBIT or Unrelated Debt Finance Income (UDFI) tax. The UDFI is part of the UBTI family and triggers the same UBTI tax. However, since a retirement account is treated as tax-exempt, such as a charity pursuant to IRC Section 501, the UBIT tax rules will apply to retirement accounts in certain instances.
In summary, UBTI is triggered if:
- Retirement account uses a nonrecourse loan to buy an asset, such as stock
- Retirement account invests in an active business through a pass-through entity, such as an LLC
Whereas UDFI is triggered if:
- An IRA uses a nonrecourse loan (real estate acquisition financing) to purchase real estate)
For 2023, the UBIT maximum tax rate is 37%, however, this does not apply if a retirement account generates less than $1,000 of net UBIT income during the year. The UBIT tax rate is subject to the trust and estate income tax rates:
In 2023 the trust income tax rates are as follows:
- 10%: $0 – $2,900
- 24%: $2,901 – $10,550
- 35%: $10,551 – $14,450
- 37%: $14,451 and higher
Hence, the 37% maximum tax rate makes UBIT a major issue for certain investors.
The 514(c)(9) UDFI Exemption
Under IRC Section 514, if an exempt organization, such as a charity or a retirement account, 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 unrelated business taxable income. Property is debt-financed if it is held to produce income, its use is not substantially related to the organization’s exempt purposes, and there is acquisition indebtedness with respect to the property. Because a retirement account does not have an exempt purpose like a charity, all debt-financed income generated by the IRA or 401(k) investment would be potentially subject to the UDFI rules.
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.
However, under IRC Section 514(c)(9), an exemption to the UDFI rules exist for a 401(K) plan that satisfies the following conditions:
Except as provided in subparagraph (B) of Code Section 514, as per Code Section 514(c)(9)(A), the term “acquisition indebtedness” does not include indebtedness incurred by a qualified organization (a charity or a retirement account) in acquiring or improving any real property. For purposes of this paragraph, an interest in a mortgage shall in no event be treated as real property.
- (i) the price for the acquisition or improvement is not a fixed amount determined as of the date of the acquisition or the completion of the improvement.
- (ii) the amount of any indebtedness or any other amount payable with respect to such indebtedness, or the time for making any payment of any such amount, is dependent, in whole or in part, upon any revenue, income, or profits derived from such real property.
- (iii) the real property is at any time after the acquisition leased by the qualified organization to the person selling such property to such organization or to any person who bears a family relationship.
- the real property is acquired by a qualified trust from, or is at any time after the acquisition leased by such trust to, any person who—
- (I) bears a relationship which is described in subparagraph (C), (E), or (G) of section 4975(e)(2) to any plan with respect to which such trust was formed, or
- (II) bears a relationship which is described in subparagraph (F) or (H) of section 4975(e)(2) to any person described in sub-clause (I);
- any person described in clause (iii) or (iv) provides the qualified organization with financing in connection with the acquisition or improvement; or
- (I) all of the partners of the partnership are qualified organizations,
- (II) each allocation to a partner of the partnership which is a qualified organization is a qualified allocation (within the meaning of section 168(h)(6)), or
- (III) such partnership meets the requirements of subparagraph (E).
The above portion of IRC Section 514(c)(9) that was put in bold was done for the purpose of illustrating that a 401(k) that invests in a real estate partnership that has acquisition indebtedness would be able to avail themselves of the exemption under 514(c)(9) so long as the partnership allocation is a qualified allocation. As per IRC Section 168(h), the term “qualified allocation” means any allocation to a tax-exempt entity which— (i) is consistent with such entity’s being allocated the same distributive share of each item of income, gain, loss, deduction, credit, and basis and such share remains the same during the entire period the entity is a partner in the partnership, and (ii) has substantial economic effect within the meaning of section 704(b)(2).
Therefore, a 401(k) can be a partner in a partnership with non-retirement account owners and still qualify for the UBTI exemption under Code Section 514(c)(9) so long as the allocation of income, gains, or losses is qualified. Note – Code Section 514(c)(9)(vi), which is bolded above, uses the term “or” versus “and” when identifying the three requirements for a partnership holding real estate to be covered by the UBTI exemption under 514(c)(9). It is for this reason, why using a 401(k) to invest in a real estate partnership using leverage is so tax beneficial. If the same investment was done with an IRA, the IRA could be subject to up to a 37% tax on a portion of the income or gains from the real estate partnership.
Who is Eligible for a Solo 401(k)?
Unfortunately, not everyone is eligible to establish a Solo 401(k), which can be adopted by a sole proprietor or any type of business entity. In general, to be eligible to benefit from the Solo 401(k) plan, one must meet just two eligibility requirements:
- The presence of self-employment activity
- The absence of full-time employees
A Solo 401(k) plan can be established with “self-directed” features, allowing it the opportunity to invest in alternative assets, such as a real estate investment fund. In addition, the plan has high annual contribution limits, a $50,000 tax-free loan option, powerful Roth options, and strong asset and creditor protection.
Hence, if one has a full-time or part-time business that has no full-time employees other than their business partner or spouse, the entity would be eligible to establish a Solo 401(k) plan and take advantage of the UBIT exception under IRC Section 514(c)(9).
If one is eligible to establish a Solo 401(k) plan, one can rollover pretax IRA or former employer 401(k) funds into the plan tax-free to fund the real estate investment and also make direct contributions up to the annual limits.
The UBIT exemption under IRC Section 514(c)(9) is one the major reasons why the Solo 401(k) plan has become such a popular retirement plan for self-employed real estate investors. Whether one is using a nonrecourse loan to buy real estate directly or via a real estate investment fund, gaining the ability to invest retirement funds using leverage without triggering UBIT is a powerful tax planning tool for many real estate investors.