Am I subject to UBTI Tax on Unrelated Debt Financed Income in a Solo 401(k) Plan?
No. Unlike a Self Directed IRA LLC, when a Solo 401K Plan uses non-recourse leverage to purchase real estate that is leveraged, it is exempt from paying any Unrelated Business Taxable Income (UBTI) tax on the income or gain generated.
When an IRA buys real estate that is leveraged with mortgage financing, it creates Unrelated Debt Financed Income (a type of Unrelated Business Taxable Income) on which taxes must be paid. A Solo 401(k) plan is exempt from UDFI pursuant to Internal Revenue Code Section 514(c)(9).
With the UBTI tax rates at approximately 35%, the Solo 401(k) Plan offers real estate investors looking to use non-recourse leverage in a transaction with a tax efficient solution.
“Debt-financed property” refers to borrowing money to purchase the real estate (i.e., a leveraged asset that is held to produce income). In such cases, only the income attributable to the financed portion of the property is taxed; gain on the profit from the sale of the leveraged assets is also UDFI (unless the debt is paid off more than 12 months before the property is sold).
Why does this Exemption Apply to 401(k) Plans and Not IRAs?
When Internal Revenue Code Section 514(c)(9) was enacted in 1980, it applied only to qualified pension, profit sharing, and stock bonus plans, but its scope was broadened in 1984 to include schools, colleges, and universities. The provision brings the history of Internal Revenue Code Section 514 full circle by exempting some organizations, such as 401(k) Qualified Plan, from tax on income from the very sort of leveraged real estate deals that provoked the enactment of the predecessor of Internal Revenue Code Section 514 in 1950. As per the legislative history, the only reason given in the committee reports for the exemption is that some people wanted it: “Trustees of these plans are desirous of investing in real estate for diversification and to offset inflation. Debt-financing is common in real estate investments.”