A self-directed IRA offers several unique opportunities for the savvy real estate investor. It is very similar to other IRAs, except that you are in charge of how and where to invest. Self-directed IRAs allow the freedom to invest in alternative assets like bonds, mutual funds, CDs, stocks, and real estate. If you are considering this investment route, it’s essential to understand the self-directed IRA tax rules.
How is a Self-Directed IRA Taxed: UBIT, UBTI and UDFI
With any investment choice, it’s important to understand potential tax risks and fees before purchasing a new asset. For self-directed IRAs that are used to invest in real estate, one of the potential factors that must be carefully considered is UBIT. With this in mind, it is important to note that contrary to popular belief, UBIT is not a penalty; instead, it can occur when an account is making money, and thus, it should be considered a cost of doing business.
What is UBIT?
UBIT refers to the tax that is paid on a UBTI or UDFI. UBIT can apply to pass through or untaxed entities used to own or operate a business. This means that if your self-directed IRA makes a debt-financed purchase, such as buying an investment property with a mortgage or loan, then UBIT can occur. UBIT would occur if you decided to rent out the investment property and were thus receiving taxable business income from your investment.
To avoid this potential tax, you can use a self-directed IRA to make 100 percent cash purchases for all real estate investments. Alternatively, deductions such as depreciation and expenses can be used to lower the net income that would otherwise be taxed via UBIT.
If you are planning on using your self-directed IRA to purchase real estate, remember to calculate the estimated yearly UBIT based on the property’s net income (if and only if you are using debt leverage to purchase the property).
What is UBTI in an IRA?
UBTI refers to the gross income from any unrelated trade or business that is regularly carried on by the exempt organization. This figure should be calculated less the deductions that are directly connected with the trade or business. In layman’s terms, UBTI can trigger the UBIT tax, which as noted in the previous section, applies to profits that are associated with a business.
For example, when your self-directed IRA invests in either a) an operating business or b) an entity that operates a business, such as an LLC. Since many real estate investments are made using an LLC for added protection, it’s important to remember that as part of your investment strategy, you should carefully calculate the estimated UBTI for the IRA.
What is UDFI?
UDFI can occur when an IRA gets a loan to increase its potential buying power further. When debt leverage occurs, such as a loan to purchase a rental property, UDFI can trigger UBIT, which can result in additional taxes. Several tactics can reduce the risk of triggering UBIT and paying additional taxes.
- UDFI applies to rental property income. Since UDFI applies to rental property income, you can reduce the financial impact by including depreciation and interest expenses for a UDFI tax loss.
- UDFI applies to gains on selling of assets. In other words, when you sell a property that your self-directed IRA purchased via a loan, then UDFI can apply.
When considering the benefits of using a debt-leverage to buy additional investment properties with your self directed IRA, you must not only calculate the UBIT, but also determine the anticipated rate of return.
With the help of your investment consultant, you can determine what properties should be purchased using cash (and thus avoiding UBIT altogether) and which properties should be bought with a loan. These properties will offer the opportunity for high rates of return and hence warrant the potential for UBIT.
Which Assets are Taxed in a Self-Directed IRA
Certain assets are taxed within a self-directed IRA. Your investment consultant can help determine which assets offer the opportunity for high rates of return and what strategy is best for your self-directed IRA based on potential taxes.
Portfolio Income
Your self-directed IRA can have a wide variety of assets that generate income. For example, interest earned, dividends, royalties, and pensions. In a self-directed IRA, these are taxed like other IRAs that generate capital gains.
Long Term Capital Gains Property & Rental Income (no Financing)
Let’s say you purchased a rental property using a self-directed IRA. By not financing a rental property, you can avoid UBIT and won’t be subject to taxes. If you are part of an LLC that invests in real estate and decide to use funds from your self-directed IRA to purchase long-term rental properties in order to avoid UBIT taxes, financing cannot be used.
Long Term Capital Gains Property & Rental Income (with Financing)
Long-term capital gains properties, such as those purchased with financing and generating a rental income, are subject to tax within your self-directed IRA. As discussed in the previous section, these properties would qualify as part of a business that earns an income and thus triggers UDFI.
In these instances, your self-directed IRA would be taxed on the income earned from either the annual rent or the future sale of the investment property.
Active Trade or Business
If you use funds from your self-directed IRA to actively trade or own/operate a business, the monies earned will be subject to tax within your IRA. This is important to remember if you use the funds from your self-directed IRA as a passive investor in a syndication or LLC.
Even though you are a passive investor, any income earned will be taxed. As such, carefully explore the potential financial gains before you decide to invest in these types of assets and thus pay UBIT taxes.
Self-Directed IRA Tax Reporting Requirements
As with any investment or retirement account, you must carefully file a tax report for the assets within your self-directed IRA. To learn more about the nuances of filing this type of report, speak with your investment consultant as well as your tax advisor.
Remember, failing to file self-directed IRA taxes properly can result in hefty fines from the IRS. It’s much better to work with a trusted industry professional than risk paying additional fees.
Obtain an EIN for an IRA
As part of the self-directed IRA tax reporting requirements, you must file an IRS Form SS-4 to obtain your Employer Identification Number (EIN). Next, use the full name of your IRA. While the SS-4 Form is available online, often the name field is too short.
UBIT Tax Filing
If your self-directed IRA is subject to UBIT, you’ll need to file certain tax forms to avoid paying additional late fees or fines. Use Line 20, Code V on Schedule K-1 on your IRA tax forms to mark any UBTI for the investment.
The good news is that you can always file for an extension using the IRS Form 8868. If payment is required, then you may also need to file CA FTB 3539. However, if the total UBTI earned exceeds $1,000, then you will need to file IRS Form 990-T and CA Form 109. If these forms and instructions seem completely foreign to you, enlist the help of an investment consultant and tax advisor.
Suggested Resources on IRA’s
Check out the following resources for additional information and help understanding how the assets within your self-directed IRA might be taxed.
- The Self-Directed IRA Handbook, by Mat Sorensen (published in 2013).
- IRS Publication 598, Tax on Unrelated Business Income of Exempt Organizations (available online).
- IRS Form 990-T and 990-T Instructions (available online).
As always, take advantage of your investment consultant and tax advisor for any other questions.
Investor Questions
1. Self-Directed 401k vs. Self-Directed IRA – Which is better from a tax perspective?
The major difference is that the UDFI tax doesn’t apply to a 401k. For example, if you are planning on leveraging a rental property that will generate a UDFI, then a 401k is the better option from a tax perspective.
2. Is the interest earned from hard money lending through my self-directed 401k taxable and which (UBIT, UBTI and UDFI apply)?
The interest earned from hard money lending through your self-directed 401k is not taxable. Thus, as stated in the previous question, UDFI (UBIT and UBTI) do not apply. As you weigh the pros and cons between investing via a self-directed IRA and a self-directed 401k, it is important that you meet with your investment consultant to discuss the type of assets (including real estate) that you would like to purchase with either your self-directed IRA and/or self-directed 401k.
3. Are Roth IRAs the same as traditional IRAs?
The short answer is “no.” Traditional IRA contributions are often tax deductible on state and federal tax returns. Roth IRAs provide no tax breaks but do offer tax-free earnings and withdrawals.
4. What happens to invested income after UBTI at the time of distribution, do we have to pay tax again?
The fact that you paid an internal tax means that you don’t have any offsetting credit. When you take the funds, they will be counted as “ordinary” income on your normal tax form.
5. Is there any way to avoid double taxation regarding UDFI?
The short answer is “no.” However, if you are eligible with self-employed income, then their isn’t any UDFI in self directed 401ks.
Final Thoughts
Understanding self-directed IRA tax rules and how a self-directed IRA is taxed when it comes to real estate investing can be a complicated process. There are several pros and cons of self-directed IRAs. Your investment consultant and tax advisor will be able to provide advice to determine a) if you want to invest in real estate by leveraging your self-directed IRA or b) how to potentially avoid UBIT, as well as other taxes.
