In a previous article, we discussed the concept of Unrelated Business Taxable Income (UBTI) as it relates to non-profit organizations. If you have a self-directed IRA, you may be surprised to know that UBTI may also apply to your IRA. An IRA is a tax-exempt entity, under IRS rules. Note that the IRA itself is the tax exempt entity and the tax would be paid by the IRA, not the owner of the IRA.
The basic rules for UBTI in an IRA are pretty much the same as for any non-profit organization, but there are a couple of issues that may be encountered more commonly with an IRA. If a non-profit entity has UBTI, it will be subject to tax on that income at the applicable corporate rates. The purpose of this is to level the playing field for for-profit entities that must pay tax on their income.
The IRS defines unrelated business taxable income as “gross income derived from any unrelated trade or business regularly conducted by the exempt organization, less the deductions directly connected with carrying on the trade or business.”
An important aspect of this definition is that it must be a trade or business regularly carried on. An annual craft fair or yard sale is not a business and is not being regularly carried on. A church that operates a restaurant, open to the public with regular business hours has a trade or business.
Exemptions from UBTI include:
3. Interest from passive loans
4. Real estate rents
5. Capital gain from the sale or exchange of investments.
There are two provisions in the law that an owner of a self-directed IRA may encounter, giving rise to the possibility of UBTI. First is income from debt-financed properties. If the IRA contains securities, real estate, or similar property that has be purchased in part or in whole with debt, the income attributable to the debt-financed portion of the property is taxed as UBTI. In the event of the sale of one of these assets, one must pay close attention to the timing of the loan payoff and the sale. In order to escape UBTI, the debt must have been paid off more than 12 months before the sale of the underlying asset.
The second “gotcha” in this situation is rental real estate. In order to qualify for exclusion from UBTI, the rental must essentially be a long-term leasing agreement. Certain rental income is subject to UBTI, including:
1. Rent tied to the income of the tenant
2. Hotel rooms
3. Boarding houses
4. Storage or warehouse space
5. Certain parking lot income
6. Other short-term rentals, such as condos generally rented for short-term periods.
Treas. Reg. § 1.512(b)-1(c)(5)6 states that “generally, services are considered rendered to the occupant if they are primarily for his convenience and are other than those usually or customarily rendered in connection with the rental of rooms or other space for occupancy only. The supplying of maid service, for example, constitutes such service; whereas the furnishing of heat and light, the cleaning of public entrances, exits, stairways and lobbies, the collection of trash, etc. are not considered as services rendered to the occupant.” If the services are provided, it would not be rental real estate and would be subject to UBTI.
The Regulation further states “Payments for the use or occupancy of entire private residences or living quarters in duplex or multiple housing units, of offices in any office building, etc., are generally treated as rent from real property.” The key to this section is the length of time for the rental and what is provided to the tenant.
It may not be a bad thing to have UBTI if the investment gives a superior return to other investment alternatives. An awareness of the possibility of UBTI in a self-directed IRA is critical, as penalties and interest could be significant and erode any gains realized from the IRA.