An Individual Retirement Account (IRA) is by definition a tax-deferred vehicle typically used to save for retirement. There is however, one item that can change the tax deferred status. That item, is Unrelated Business Income Tax (UBIT). UBIT is an additional tax on certain tax-exempt entities from income earned outside of the main function of the entity. While capital gains or ordinary income tax are household names, UBIT is unfamiliar for most people and easily misunderstood. This is a tax usually applied to IRA investing in positions outside the traditional capital markets.
How is the tax generated?
While there are many alternative investments available to the general public through an IRA, it’s typically only those with debt financing that will trigger UBIT. Income generated from debt financing (ex: debt used to purchase an apartment complex) will most likely generate UBIT. Generally, IRA investments that generate UBIT include limited partnerships and limited liability companies because this would be considered income unrelated to the primary purpose of the IRA. Any investment that earns interest is not taxed immediately due to the tax-exempt status which allows compound interest to take effect. If there is an investment unrelated to the primary purpose of the IRA, the UBIT overrides the tax-exempt status and triggers an additional tax that’s otherwise avoided.
How much is owed?
The amount owed for UBIT is directly related to the % of debt on the specific investment. If there is 50% debt on a real estate property then 50% of the profit is subject to UBIT. (See below for tax rates.) Action steps are only needed if the taxable income generated from the investment is greater than $1,000.
Who is responsible?
If an investor finds themselves in a position to owe UBIT, this tax will be applied at the entity level, not the individual. Because the IRA technically generated the tax, the IRA would owe the tax instead of the individual. Any tax liability owed by the IRA has no impact on a person’s individual return—it is completely distinct and separate.
What forms are filed?
Because the IRA is the entity that owes the tax, the account owner would apply for an IRA EIN and file Form 990-T. This would be a separate tax return outside of the individual’s 1040. The 990-T is due four months after the end of the tax year.
What are the tax rates?
The UBIT falls under the trust tax rates which are subject to annual adjustments. For 2016 they are:
- 15% under $2,550
- 25% between $2,551 – $5,950
- 28% between $5,951 – $9,050
- 33% between $9,051 – $12,400
- 6% on any amount above $12,401
What deductions are allowed?
The UBIT is only required to be reported if the income generated is over $1,000. There are deductions available to the income generated that can reduce taxable profit. Expenses, depreciation and similar items that are connected to the unrelated business activities are deductible. Also, net operating losses qualify as a deduction. UBIT can be unique for a real estate investment. For example, a real estate project may not pay much income (under $1,000) each year while it’s being held. Then, the property distributes a large return (over $1,000) upon the sale which would trigger the UBIT, but not until the return is over $1,000.
At the end of the day, UBIT is not a tax to be feared or purposefully avoided, but rather realize that it is triggered by your investments distributing funds, which is a good problem to have. While not tax experts, the advisors at Box Financial would be willing to further assist you with any questions you may have related to alternative investments held by your IRA, including questions about UBIT.