The tax advantage of an IRA is that income is tax-free until distributed. In general, an exempt organization is not taxed on its income from an activity that is substantially related to the charitable, educational, or other purpose that is the basis for the organization’s exemption. Such income is exempt even if the activity is a trade or business. However, to prevent tax-exempt entities from competing unfairly with taxable entities, tax-exempt entities are subject to unrelated business taxable income (UBTI) when their income is derived from any trade or business that is unrelated to its tax-exempt status.
UBTI is defined as “gross income derived by any organization from any unrelated trade or business regularly carried on by it” reduced by deductions directly connected with the business. An exempt organization that is a limited partner, member of a LLC, or member of another non-corporate entity will have attributed to it the UBTI of the enterprise as if it were the direct recipient of its share of the entity’s income which would be UBTI had it carried on the business of the entity. UBTI also applies to unrelated debt-financed income (UDFI). “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). There are some important exceptions from UBTI: those exclusions relate to the central importance of investment in real estate – dividends, interest, annuities, royalties, most rentals from real estate, and gains/losses from the sale of real estate. However, rental income generated from real estate that is “debt financed” loses the exclusion, and that portion of the income becomes subject to UBTI. Thus, if the IRA borrows money to finance the purchase of real estate, the portion of the rental income attributable to that debt will be taxable as UBTI.
For an IRA, any business regularly carried on or by a partnership or LLC of which it is a member is an unrelated business. For example, the operation of a shoe factory, the operation of a gas station, or the operation of a computer rental business by an LLC or partnership owned by the Self Directed IRA LLC would likely be treated as an unrelated business and subject to UBTI.
Although there is little formal guidance on UBTI implications for self-directed real estate IRAs, there is a great deal of guidance on UBTI implications for real estate transactions by tax-exempt entities. In general, Gains and losses on dispositions of property (including casualties and other involuntary dispositions) are excluded from UBTI unless the property is inventory or property held primarily for sale to customers in the ordinary course of an unrelated trade or business. This exclusion covers gains and losses on dispositions of property used in an unrelated trade or business, as long as the property was not held for sale to customers. In addition, subject to a number of conditions, if an exempt organization acquires real property or mortgages held by a financial institution in conservatorship or receivership, gains on dispositions of the property are excluded from UBTI, even if the property is held for sale to customers in the ordinary course of business. The purpose of the provision seems to be to allow an exempt organization to acquire a package of assets of an insolvent financial institution with assurance that parts of the package can be sold off without risk of the re-sales tainting the organization as a dealer and thus subjecting gains on re-sales to the UBIT.