This article, written by Adam Bergman, originally appeared on Forbes.com –
For many retirement account investors, understanding how the Unrelated Business Taxable Income Rules work, also known as UBTI, UBIT, or debt-financed income rules, and how they may potentially apply to one’s retirement account investment has been a challenge. The main reason is that the majority of IRA or 401(k) plan investors invest in traditional types of investments, such as equities, mutual funds, and ETFs, which do not trigger the application of the UBTI tax rules since most passive investments that a retirement account might invest in are exempt from the UBTI rules, such as interest, dividends, and capital gains.
Understanding the potential impact of the UBTI rules is crucial for retirement account investors seeking to make non-real estate alternative investments in their retirement accounts, including options, stock short sales, and commodity futures contracts. In general, the UBTI tax rules are triggered in three instances: (i) use of margin to buy stock, (ii) use of a non-recourse loan to buy real estate, and (iii) investment in a business operated through a flow-through entity, such as an LLC or partnership. The tax imposed by triggering the UBTI rules is quite steep and can go as high as 40 percent.
When it comes to non-real estate transactions, such as securities and other financial products involving retirement funds, understanding the application of the UBTI or debt-financed income rules have been somewhat difficult. Neither the Code nor the Treasury regulations define “indebtedness” for purposes of the debt-financed income rules. Generally, when a retirement account borrows funds and has a clear obligation to repay the funds, the debt-financed income rules are applicable. However, many financial product type investments that involve “leverage” but not a direct borrowing are not considered debt-financed property and are not subject to UBIT.
Below is a summary of how the UBTI/debt-financed income rules apply to some of the more common type of financial product investments involving retirement funds:
Purchase of Stock or Securities on Margin: It is well established that the purchase of securities on margin gives rise to unrelated debt-financed income (Elliott Knitwear Profit Sharing Plan v. Commissioner, 614 F.2d 347 (3d Cir. 1980).
Repurchase Agreements: In a repurchase agreement, one party (usually a bank) purchases securities from another party (the bank’s customer) and agrees to sell the securities back to the customer at an agreed price. Such transactions are treated as a loan of money secured by the securities and give rise to unrelated debt financed income (Rev. Rul. 74-27, 1974-1)
Securities Lending Transactions: IRC Section 514(c)(8) provides that payments with respect to securities loans are deemed to be derived from the securities loaned, not from collateral security or the investment of collateral security from such loans.
Short Sales of Stock: The IRS has ruled that neither the gain attributable to the decline in the price of the stock sold short nor the income earned on the proceeds of the short sale held as collateral by the broker constituted debt-financed income (Rev. Rul. 95-8, 1995-1)