The Government Accountability Office (“GAO”) issued their most recent report on self-directed IRAs and concluded that the IRS and DOL should do more to collaborate on prohibited transactions in IRAs. The report and the GAO’s work was an excellent analysis of some of the issues facing IRA owners.
There were two significant sections in the report for Self-Directed IRA accounts: Prohibited transaction exemption applications and IRAs with large balances likely being self-directed.
Prohibited Transaction Exemption Applications
An IRA owner may request an exemption for a prohibited transaction by making a formal written request to the DOL. While the IRS enforces the prohibited transaction rules, the DOL has interpretative authority and is the agency who can grant exemptions. An exemption must be obtained in advance of the transaction and takes on average one year to obtain.
A common prohibited transaction exemption request is one where the IRA owner owns real estate in an IRA which they would like to use personally. While the property could be distributed as an in-kind distribution there are tax consequences to such distribution. The DOL has granted this exemption request for IRA owners in the past and generally requires an appraisal to set the value and a broker/agent to effectuate the transaction.
The prohibited transaction exemption process is rarely utilized by IRA owners. The GAO noted that in the past 11 years only 48 prohibited transaction exemptions where granted for IRAs.
The biggest deterrent from my experience with clients is that it takes 6 months to 1 year to get approved and about $5,000 in legal fees to make the application and handle it to decision. Usually such long timelines are not something IRA owners are willing to wait on as circumstances change from one year to the next. The DOL does have some expedited prohibited transaction exemption procedures, known as EXPRO, that can be used when an account owner is seeking to rely on an exemption that has already been granted by the DOL to someone in a similar situation. Use of such procedures with IRA owners, which is already allowed but not readily known, could provide a better outcome as EXPRO applications are granted more quickly.
The GAO recommended that the IRS and DOL collaborate on prohibited transaction exemptions to better regulate and understand IRAs.
IRAs With Large Balances Likely Self-Directed
In their report, the GAO also noted some of their prior work on self-directed IRAs and stated the following:
“…IRA owners who have accumulated unusually large IRA balances likely have invested in unconventional assets like non-publicly traded shares of stock and partnership interests.”
While this is no news to self-directed IRA owners, it should be something of interest to policy makers and financial advisers who may view self-directed accounts with skepticism. If self-directed accounts have proven to get unusually high balances, wouldn’t we want more people to use them to do the same thing and to secure their retirement. The concept of self-directed IRAs is simple: Give more freedom and control, and let people invest in what they know. Let account owners decide and obtain the benefits (or burden) of their decisions with their money. Sure, there are risks but the best person to take risks is the person whose actual hard-earned money is on the line.
Unrelated Business Income Tax (“UBIT”) is often misunderstood by self-directed IRA investors and their professional advisors. In essence, UBIT is a tax that is due to an IRA when it receives “business income” as opposed to “investment income”. When we think of IRAs and retirement accounts, we think of them as receiving income without having to pay tax when the income is made. For example, when your IRA sells stock for a profit and that profit goes back to your IRA you don’t pay any tax on the gain. Similarly, when you sell real estate owned by your IRA for a profit and that profit goes back to your IRA, you don’t pay any tax on the gain. The reason for this is because the gain from the sale of an investment asset is deemed investment income and as a result it is exempt for UBIT tax.
Tip 1: “When Does UBIT Apply?”
UBIT applies when your IRA receives “unrelated business income”. However, if your IRA receives investment income, then that income is exempt from UBIT tax. Investment income that is exempt from UBIT includes the following.
Investment Income Exempt from UBIT:
- Real Estate Rental Income, IRC 512(b)(3) – The rent of real estate is investment income and is exempt from UBIT
- Interest Income, IRC 512(b)(1) – Interest and points made from the lending of money is investment income and is exempt from UBIT.
- Capital Gain Income, IRC 512(b)(5) – The sale, exchange, or disposition of assets is investment income and is exempt from UBIT.
- Dividend Income, IRC 512(b)(1) – Dividend income from a c-corp where the company paid corporate tax is investment income and exempt from UBIT.
- Royalty Income, IRC 512(b)(2) – Royalty income derived from intangible property rights such as intellectual property and from oil/gas and mineral leasing activities is investment income and is exempt from UBIT.
There are two common areas where self-directed IRA investors run into UBIT issues and are outside of the exemptions outlined above. The first occurs when an IRA invests and buys LLC ownership in an operating business (e.g. sells goods or services) that is structured as a pass-thru entity for taxes (e.g. partnership) and that that does not pay corporate taxes. The income from the LLC flows to its owners and would be ordinary income. If the company has net taxable income it will flow down to the IRA as ordinary income on the k-1 and this will cause tax to the IRA as this will be business income and it does not fit into one of the investment income exemptions.
The second problematic area is when IRAs engage in real estate investment that do not result in investment income. For example, real estate development or a number of significant short-term real estate flips by an IRA will cause the assets of the IRA to be considered as inventory as opposed to investment assets and this will cause UBIT tax to the IRA.
Tip 2: UBIT Applies When You Have Debt Leveraging an IRA Investment
UBIT also applies to an IRA when it leverages its purchasing power with debt. If an IRA uses debt to buy an investment, then the income attributable to the debt is subject to UBIT. This income is referred to as unrelated debt financed income (UDFI) and it causes UBIT. The most common situation occurs when an IRA buys real estate with a non-recourse loan. For example, lets say an IRA buys a rental property for $100,000 and that $40,000 came from the IRA and $60,000 came form a non-recourse loan. The property is thus 60% leveraged and as a result, 60% of the income is not a result of the IRAs investment but the result of the debt invested. Because of this debt, that is not retirement plan money, the IRS requires tax to be paid on 60% of the income. So, if there is $10K of rental income on the property then $6K would be UDFI and would be subject to UBIT taxes.
For a more detailed outline on UDFI, please refer to my free one-hour webinar here.
Tip 3: UBIT Tax is Reported and Paid by the IRA via a Form 990-T Tax Return
Unrelated business income tax (UBIT) for an IRA is reported and paid via IRS Form 990-T. IRS Form 990-T is due for IRAs on April 15th of each year. IRA owner’s can file and obtain an automatic 6-month extension with the IRS by filing an extension request before the regular deadline.
If UBTI Tax is due, it is paid from the IRA and the IRA owner would send the prepared Form 990-T to their IRA custodian for their signature and for direction of payment to the IRS for any tax due as part of the 990-T Return.
For a more detailed outline of UBIT, please refer to Chapter 15 of The Self Directed IRA Handbook.
An IRA may invest into a real estate investment trust. Real estate investment trusts (“REIT”) are trusts whereby the company undertakes certain real estate activities (e.g. own or lend on real estate) and returns profits to its owners. An IRA may invest and be an owner in a REIT. As many self directed IRA investors know, a form of unrelated business income tax (“UBIT” tax) known as unrelated debt financed income tax (“UDFI” tax) can arise from real estate leveraged by debt.
Many REITs engage in real estate development activities and/or use debt to leverage their cash purchasing power and as a result may cause a form of UBIT tax known as UDFI tax to IRA owners. Most REITS will not pay corporate taxes and as a result will not be considered exempt from UBIT tax as a result of having paid corporate tax. However, income from REITs is still typically exempt from UBIT and UDFI tax because the definition of a “qualified dividend” in a REIT has been defined to include dividends paid by a REIT to its owners. IRS Revenue Ruling 66-106. Qualified dividends from a REIT are exempt from UBIT and UDFI tax. REITs can be publically traded or private trusts but are not easy to establish. They require at least 100 owners and must distribute at least 90% of their taxable earnings to their owners each year. Despite the general application of exception to UBIT/UDFI tax for REITs, a REIT may be operated in a manner that will not allow for qualified dividends to be paid and therefore income from the REIT would not be exempt from UBIT/UDFI tax. If you’re investing into a REIT with an IRA, make sure you know whether the REIT intends to be exempt from UBIT/UDFI tax or not. As discussed, most will be exempt from UBIT/UDFI tax but some REITs may choose to operate in ways that will not qualify for the exception. Because UBIT/UDFI tax is about 39% at $10,000 of annual income this is something every IRA should understand before investing into a REIT.