It’s finally here: My top ten list of frequently asked self-directed IRA questions! Whether you’re just getting started or you’ve been investing with a self-directed account for decades, make sure you know the answers to these ten questions. In most instances, I’ve linked to more comprehensive articles and videos on the subject. And of course, you can always crack open the best-selling book on the subject for even more information and detail: The Self Directed IRA Handbook.
1. What is a self-directed IRA?
A self-directed IRA is an IRA (Roth, Traditional, SEP, Inherited IRA, SIMPLE) where the custodian of the account allows the IRA to invest into any investment allowed by law. These investments typically include: Real estate, promissory notes, precious metals, and private company stock. The typical reaction I hear from investors is, “Why haven’t I ever heard of self-directed IRAs before, and why can I only invest my current retirement plan into mutual funds or stocks?” The reason is that large financial institutions that administer most U.S. retirement accounts don’t find it administratively feasible to hold real estate or non-publicly traded assets in retirement plans.
2. Can I rollover or transfer my existing retirement
account to a self-directed IRA?
Well, it depends. Here’s my chart that breaks down every possible scenario:
|I have a 401(k) account with a former employer.||Yes, you can rollover to a self directed IRA. If it is a Traditional 401(k), it will be a self-directed IRA. If it is a Roth 401(k), it will be a self-directed Roth IRA.|
|I have a 403(b) account with a former employer.||Yes, you can roll-over to a Traditional self-directed IRA.|
|I have a Traditional IRA with a bank or brokerage.||Yes, you can transfer to a self-directed IRA.|
|I have a Roth IRA with a bank or brokerage.||Yes, you can transfer to a self-directed Roth IRA.|
|I inherited an IRA and keep the account with a brokerage or bank as an inherited IRA.||Yes, you can transfer to a self-directed inherited IRA.|
|I don’t have any retirement accounts but want to establish a new self-directed IRA.||Yes, you can establish a new Traditional or Roth self-directed IRA, and can make new contributions according to the contribution limits and rules found in IRS Publication 590.|
|I have a 401(k) or other company plan with a current employer.||No, in most instances your current employer’s plan will restrict you from rolling funds out of that plan. However, some plans do allow for an in-service withdrawal if you are at retirement age.|
3. What can a self-directed IRA invest in?
Under current law, a retirement account is only restricted from investing in the following:
And, any investment that constitutes a prohibited transaction pursuant to ERISA and/or IRC 4975 (e.g. purchase of any investment from a disqualified person such as a close family member to the retirement account owner).
The most popular self-directed retirement account investments include:
- Rental real estate;
- Secured loans to others for real estate (trust deed lending);
- Private small business stock or LLC interest; and
- Precious metals, such as gold or silver.
These investments are all allowed by law and can be great assets for investors with experience in these areas.
4. What restrictions are there on using a self-directed IRA?
When self-directing your retirement account, you must be aware of the prohibited transaction rules found in IRC 4975. These rules don’t restrict what your account can invest in, but rather, whom your IRA may transact with. In short, the prohibited transaction rules restrict your retirement account from engaging in a transaction with someone who is a disqualified person to your account. A disqualified person to a retirement account includes: The account owner, their spouse, children, parents, and certain business partners. So, for example, your retirement account could not buy a rental property that is owned by your father since a purchase of the property would be a transaction with someone who is disqualified to the retirement account (e.g. father). On the other hand, your retirement account could buy a rental property from your cousin, friend, sister, or a random third-party, as these parties are not disqualified persons under the rules.
Here’s a diagram outlining who is disqualified to your IRA:
Prohibited transactions should be avoided as the consequence is distribution of the entire account involved.
5. Can my self-directed IRA invest in my
personal business, company, or deal?
No, it would violate the prohibited transaction rules if your IRA transacted with you personally (or with a company you own). In addition, your IRA cannot transact with or benefit anyone who is a disqualified person (e.g. IRA owner, spouse, children, parents, spouses of children, etc.)
6. What is a checkbook-control IRA or IRA/LLC?
Many self-directed retirement account owners, particularly those buying real estate, use an IRA/LLC (aka “checkbook-control IRA”) as the vehicle to hold their retirement account assets. An IRA/LLC is a special type of LLC, which consists of an IRA (or other retirement account) investing its cash into a newly created LLC. The IRA/LLC is managed by the IRA owner, and the IRA owner then directs the LLC investments and the LLC to take title to the assets, pay the expenses to the investment, and receive the income from the investment. There are many restrictions against the IRA owner being the manager (such as not receiving compensation or personal benefit) and many laws to consider, so please ensure you consult an attorney before establishing an IRA/LLC. For more details on the IRA/LLC structure, including cases and structuring options, please refer to my blog post, “New Case Answers Important Questions about IRA/LLCs.”
Here’s a simple diagram that outlines how the IRA/LLC (checkbook-control IRA) operates:
7. Can my IRA invest cash and can I get a
loan to buy real estate with my IRA?
Your IRA can buy real estate using its own cash and a loan/mortgage to acquire the property. Whenever you leverage your IRA with debt, however, you must be aware of two things. First, the loan your IRA obtains must be a non-recourse loan. A non-recourse loan is made by the lender against the asset, and in the event of default the sole recourse of the lender is to foreclose and take back the asset. The lender cannot pursue the IRA or the IRA owner for any deficiency. Second, your IRA may be subject to a tax known as unrelated debt financed income tax (UDFI/UBIT).
8. Are there any tax traps? What about UBIT/UBTI?
The tax 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 exempt from UBIT includes the following.
- Real Estate Rental Income (IRC 512(b)(3)) – Rent from real estate is investment income, and is exempt from UBIT.
- Interest Income (IRC 512(b)(1)) – Interest and points made from the money lending 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.
So, make sure your IRA receives investment income as opposed to “business income”.
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 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. If your IRA has UBIT income, it must file it’s own tax return using IRS Form 990-T. The second instance occurs when the IRA invests into real estate activities whereby the IRA is deemed to be in the business of real estate as opposed to investing in real estate (e.g. real estate development, construction, significant short-term real estate flips).
9. What is unrelated debt financed income (UDFI)?
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, let’s say an IRA buys a rental property for $100,000, and that $40,000 came from the IRA and $60,000 came from 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, which is not retirement plan money, the IRS requires tax to be paid on 60% of the income. So, if there is $10K of net 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.
10. Should I use a solo 401(k) instead of a self-directed IRA?
A solo 401(k) is a great self-directed account option, and can be used instead of an IRA for persons who are self-employed with no other employees (other than business owners and spouses). If you are not self-employed, then the solo K will not work in your situation.
A solo 401(k) is generally a better option for someone who is self-employed and still trying to maximize contributions, as the solo 401(k) has much higher contribution amounts ($54,000 annually versus $5,500 annually for an IRA). On the other hand, a self-directed IRA is a better option for someone who has already saved for retirement and who has enough funds in their retirement accounts which can be rolled over and invested via a self-directed IRA as the self-directed IRA is easier and cheaper to establish.
Another major consideration in deciding between a solo 401(k) and a self-directed IRA is whether there will be debt on real estate investments. If there is debt and the account owner is self-employed, they are much better off choosing a solo 401(k) over an IRA as solo 401(k)s are exempt from UDFI tax on leveraged real estate.
Here’s what the solo 401(k) look like and how the money flows:
Choosing between a self-directed IRA and a solo 401(k) is a critical decision when you start self-directing your retirement. Make sure you consider all of the differences before you establish your new account. Check out my blog article and video outlining the differences between self-directed IRAs and solo 401(k)s.
The IRS recently released updated the extension rules for 990-T tax returns that are required for certain self-directed IRAs. Form 990-T is a tax return that must be filed by an IRA when it receives what is known as unrelated business taxable income (“UBTI”). For a description on UBTI and 990-T returns in general, see my prior article here.
The new rules allow an IRA to receive a automatic 6 month extension of time to file by filing IRS Form 8868. Previously, IRAs required to file a 990-T, were only allowed an automatic 3 month extension. The new extension procedures were released in January 2017 and apply to 2016 990-T returns. To claim the extension, the IRA must take the following steps.
- Obtain a Tax ID/EIN for the IRA. Generally, IRAs do not have their own Tax ID/EIN and they should not obtain one, except when a 990-T return needs to be filed. The Tax ID/EIN can be obtained at IRS.gov.
- Complete and File the Extension Request Using IRS Form 8868. The automatic 6-month extension for the filing of a 990-T is obtained by filing IRS Form 8868.
- File the Extension by April 15th. The regular filing deadline for form 990-T is the 15th day of the fourth month following the tax year (e.g. April 15th each year). Make sure the extension is filed by April 15th and keep a copy as you’ll need to send a copy with the extended return. Keep in mind, the extension to file is not an extension to pay so if you end up owing UBIT and if your IRA hasn’t made any tax deposits you may have a small amount of penalty and interest due when you later file and pay.
If your self-directed IRA investments are running into UBIT, make sure you’re reporting and paying any applicable UBIT via form 990-T to the IRS. Failure to do so can result in penalties, interest, and potentially loss of the IRA’s tax preferred status. If you’re not ready to file by April 15th, make sure you file the automatic extension request to give yourself 6 more months to file.
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 (UDFI) 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 3-month extension with the IRS by filing an extension request before the regular deadline.
If UBIT 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.
Self-Directed IRA investors should be aware of the following IRA tax reporting responsibilities. Some of these items are completed by your custodian and some of them are the IRA owner’s sole responsibility. Here’s a quick summary of what should be reported to the IRS each year for your self-directed IRA.
IRA CUSTODIAN FILES – Your IRA Custodian will file the following forms to the IRS annually.
|IRS FORM||PURPOSE||WHAT DOES IT REPORT|
|Form 5498||Filed to the IRS by your custodian. No taxes are due or paid as a result of Form 5498.|| |
IRA contributions, roth conversions, the accounts fair market value as of 12/31/15, and required minimum distributions taken.
|Form 1099-R||Filed to the IRS by your custodian to report any distributions or Roth conversions. The amounts distributed or converted are generally subject to tax and are claimed on your personal tax return.||IRA distributions for the year, Roth IRA conversions, and also rollovers that are not direct IRA trustee to IRA trustee.|
IRA OWNER RESPONSIBILITY – Depending on your self-directed IRA investments, you may be required to file the following tax return(s) with the IRS for your IRA’s investments/income.
|IRS FORM||DOES MY IRA NEED TO FILE THIS?||DUE DATE|
|1065 Partnership Tax Return||If your IRA is an owner in an LLC, LP, or other partnership, then the Partnership should file a 1065 Tax Return for the company to the IRS and should issue a K-1 to your IRA for its share of income or loss. Make sure the accountant preparing the company return knows to use your custodian’s tax ID for your IRA’s K-1’s and not your personal SSN (or your IRAs Tax ID if it has one for UBIT 990-T tax return purposes). If your IRA owns an LLC 100%, then it is disregarded for tax purposes (single member LLC) and the LLC does not need to file a tax return to the IRS.|
|April 15th, 6 month extension available|
|990-T IRA Tax Return (UBIT)||If your IRA incurs unrelated business income tax (UBIT), then it is required to file a tax return. The IRA files a tax return and any taxes due are paid from the IRA. Most self-directed IRAs don’t need to file a 990-T for their IRA, buy you may be required to file for your IRA if your IRA obtained a non-recourse loan to buy a property (UDFI tax), or if your IRA participates in non-passive real estate investments such as construction, development, or on-going short-term flips. You may also have UBIT if your IRA has received income from an active trade or business such as a being a partner in an LLC that sells goods and services (c-corp dividends exempt). Rental real estate income (no debt leverage), interest income, capital gain income, and dividend income are exempt from UBIT tax.||April 15th, 3 month extension available|
I’ve answered the most frequently asked questions below as they relate to your IRA’s tax reporting responsibilities.
Q: My IRA is a member in an LLC with other investors. What should I tell the accountant preparing the tax return about reporting profit/loss for my IRA?
A: Let your accountant know that the IRA should receive the K-1 (e.g. ABC Trust Company FBO John Doe IRA) and that they should use the Tax-ID of your custodian and not your personal SSN. Contact your custodian to obtain their Tax ID. Most custodians are familiar with this process so it should be readily available.
Q: Why do I need to provide an annual valuation to my custodian for the LLC (or other company) my IRA owns?
A: Your IRA custodian must report your IRA’s fair market value as of the end of the year (as of 12/31/15) to the IRS on Form 5498 and in order to do this they must have an accurate record of the value of your IRA’s investments. If your IRA owns an LLC, they need to know the value of that LLC. For example, let’s say you have an IRA that owns an LLC 100% and that this LLC owns a rental property and that it also has a bank account with some cash. If the value of the rental property at the end of the year was $150,000 and if the cash in the LLC bank account is $15,000, then the value of the LLC at the end of the year is $165,000.
Q: I have a property owned by my IRA and I obtained a non-recourse loan to purchase the property. Does my IRA need to file a 990-T tax return?
A: Probably. A 990-T tax return is required if your IRA has income subject to UBIT tax. There is a tax called UDFI tax (unrelated debt financed income) that is triggered when your IRA uses debt to acquire an asset. Essentially, what the IRS does in this situation is they make you apportion the percent of your investment that is the IRAs cash (tax favorable treatment) and the portion that is debt (subject to UDFI/UBIT tax) and your IRA ends up paying taxes on the profits that are generated from the debt as this is non-retirement plan money. If you have rental income for the year, then you can use expenses to offset this income. However, if you have $1,000 or more of gross income subject to UBIT then you should file a 990-T tax return. In addition, if you have losses for the year you may want to file 990-T to claim those losses as they can carry-forward to be used to offset future gains (e.g. sale of the property).
Q: How do I file a 990-T tax return for my IRA?
A: This is filed by your IRA and is not part of your personal tax return. If tax is due, you will need to send the completed tax form to your IRA custodian along with an instruction to pay the tax due and your custodian will pay the taxes owed from the IRA to the IRS. Your IRA must obtain its own Tax ID to file Form 990-T. Your IRA custodian does not file this form or report UBIT tax to the IRS for your IRA. This is the IRA owner’s responsibility. Our law firm prepares and files 990-T tax returns for our self-directed IRA and 401(k) clients. Contact us at the law firm if you need assistance.
Sadly, not many professionals are familiar with the rules and tax procedures for self-directed IRAs so it is important to seek out those attorneys, accountants, and CPAs who can help you understand your self-directed IRA tax reporting obligations. Our law firm routinely advises clients and their accountants on the rules and procedures that I have summarized in this article and we can also prepare and file your 990-T tax return.
By: Mat Sorensen, Attorney and best-selling author of The Self Directed IRA Handbook.
The most common asset class for self-directed IRA accounts is real estate. Real estate investments for self-directed IRAs come in various forms from simple single-family rentals owned 100% by the IRA to LLC or LP investment partnerships with multiple investors in larger commercial or multi-family properties.
Given the changes in federal securities laws that now allow investment sponsors and real estate syndicators to raise capital more easily, many self directed IRA investors have considered investing their IRAs into these offerings. Crowdfunding sites such as Realcrowd are already offering Crowdfunding type investment opportunities for investors under SEC Rule 506(c). This rule and those investments are currently only available to accredited investors and have no restriction on the investment amount that may come from the accredited investor. These offerings have traditionally been known as private placements or “PPMs” but can now be marketed and there is no requirement that they be “private” so long as the offering company only accepts accredited investors.
For those who are not accredited investors, “true” Crowdfunding under Title III of the JOBS Act goes into effect in May of 2016. Under these Crowdfunding offerings everyone will be able to invest into Crowdfunding opportunities and the investment amount will be based on the investor’s income and assets. These new Crowdfunding rules were enacted in Title III of the JOBS Act and were put into final regulations by the SEC in late 2015.
Before investing your self-directed IRA into a real estate Crowdfunding offering, you must first learn and understand one very important tax called UBIT tax that may apply to your self-directed IRA’s income.
Will My IRA Be Subject to UBIT Tax?
Unrelated Business Income Tax (“UBIT”) applies to an IRA that receives non-passive income. UBIT is a hefty tax and has a maximum rate of 39.6%. IRC § 511. The tax table is copied below.
2016 UBIT Tax Rates
| If taxable income is:||The tax is:|
|Not over $2550||15% of the taxable income|
|Over $2550 but not over $5950||$375 plus 25% of the excess over $2550|
|Over $5950 but not over $9050||$1225 plus 28% of the excess over $5950|
|Over $9050 but not over $12300||$2107 plus 33% of the excess over $9050|
|Over $12400||$3179 plus 39.6% of the excess over $12400|
Although not shown on the table, the first $1,000 in UBIT gross income is exempt and you receive an automatic $1,000 deduction.
UBIT will apply to your self-directed IRAs real estate investment in two scenarios. First, it will apply if the income to the IRA is ordinary. And second, it will apply if the offering company uses debt to acquire its properties.
Does UBIT Apply, Step 1: Is the income passive?
First, UBIT will apply if the investment is an ordinary income producing business. An ordinary income business in real estate investing would include investing into an LLC or LP that conducts new construction, real estate developments held for sale, or other activities that are deemed business activities. Passive income investments, on the other hand, are specifically exempt from UBIT and include real estate rental income, capital gain income, interest income, and dividend income from a c-corp. IRC § 512(b). The vast majority of real estate Crowdfunding offerings are structured to obtain passive income such as rental income while the property is held and capital gain income when the property is sold. Typical real estate offerings where UBIT can be due include offerings to fix and flip properties or offerings for new construction or real estate development where the investment strategy is to buy properties to then immediately sale.
If you have an investment offering that is ordinary income (e.g. a fix and flip fund), then the income to the IRA from the fund will be subject to UBIT tax and the IRA will be required to file and pay the tax each year by using IRS Form 990-T. This responsibility to file the return each year is on the IRA account owner and not the investment sponsor or the IRA custodian so IRA owners need to know for themselves whether the IRA is subject to UBIT or not. So for example, let’s say that a self-directed IRA invested into a Crowdfunding offering that was a real estate development with properties held immediately for sale and that the income was ordinary income. Let’s further assume that the self-directed IRA received a K-1 for profits to the IRA for the year of $10,000. Based on the UBIT tax table, the IRA would owe UBIT tax in the amount of $2,420. This amount is due from the IRA to the IRS and is reported and payable using form 990-T.
If you’ve determined that the Crowdfunding offering income is passive (e.g. rental, capital gain), then you may still be subject to UBIT if the LLC or LP offering company is using debt to leverage and acquire its properties.
Does UBIT apply, Step 2: Will the investment be leveraged with debt?
Second, UBIT will apply to profits returned to your IRA from a Crowdfunding real estate offering (and really any real estate owned by your IRA) if the offering company uses debt to leverage its acquisition of properties. For example, let’s say the offering company raises $1M in cash to buy a $4M multi-family property. There will be $1M of cash invested into the property and $3M of debt. The property will therefore be leveraged 75% with debt.
Whenever an IRA’s investment is leveraged with debt, the tax code requires the IRA owner to determine what profits are attributable to the IRAs cash and what profits are attributable to the debt. The profits attributable to the cash invested is still treated as tax deferred (traditional IRA) or tax free (roth IRA) and is not subject to UBIT. The profits and income attributable to the debt, however, is called unrelated debt financed income (“UDFI”) and is subject to UBIT. IRC § 514. So, in the multi-family property example above where the property is leveraged 75% with debt, the self-directed IRA will be subject to UBIT tax on 75% of the income.
In order to calculate UBIT tax based on debt, you must first determine the leverage ratio. Once we know the leverage ratio, we can then begin to calculate how UBIT will apply. The good news is that the IRA is also allowed to take expenses against the property using the same leverage ratio and is able to take depreciation expenses which help to offset UBIT. In many situations, even where a property is cash-flowing the IRA will not be subject to UBIT because the property expenses and depreciation will offset UBIT income.
Let’s continue through this example to illustrate how this works.
Property Purchase Price = $4M
Debt/Leverage = $3M
Leverage Ration = 75%
Income = $1.3M
Income at Leverage Ratio (75%) = $975,000
Operating Expenses= $1,000,000
Operating Expenses at Leverage Ratio (75%) = $750,000
Net Leveraged Income = $225,000
Depreciation Expense ($4M / 27.5) = $145,500
Depreciation Expense at Leverage Ratio = $109,125
Net UDFI/UBIT Income = $115,875
SDIRA Investor Invested $20K and received 1.5% of Company Profit/Loss
SDIRA Investor 1.5% of Net UDFI/UBIT = $1,738.
Automatic IRS $1,000 deduction = $738 subject to UBIT/UDFI
UBIT Table Rate of 15% of $738 = $110 in UBIT is Due
As the example demonstrates, given the low-level of investment from the IRA it isn’t subject to much UBIT as the net UBIT income (after expenses and depreciation) keeps the tax rate on the low end of the tax table. That being said, 990-T tax returns must be filed by the IRA investor for the IRA and the IRA will be responsible for the tax due. Factors that will cause more UBIT are higher returns and income, larger investment amounts and ownership, and more leverage.
While self-directed IRA’s are subject to UDFI and UBIT on leveraged real estate investments, it is worth noting that self-directed 401(k) and other employer based plans are exempt from UDFI on leveraged real estate investments. IRC § 514(9). Unfortunately, self-directed IRAs do not receive this exemption.
So, in short, the quick list to determine whether UBIT will be due a self-directed IRA Crowdfunding real estate investment requires analysis of two issues. First, is the offering company’s income passive or is it ordinary. If it is ordinary then it is subject to UBIT. If it is passive, then it is only subject to UBIT if the company uses debt to leverage its investments. Once you can answer these questions you know whether UBIT will apply to your investment and whether your IRA will need to report and pay tax on its income.