Self-Directed IRAs and UBIT
If you hold an individual retirement account (IRA), then you likely know of the special tax advantages of this popular investment vehicle. Like other tax-exempt vehicles (including larger entities like pension plans, foundations, and endowments), IRAs can generate investment income that is exempt from federal income tax under certain conditions. Under traditional IRAs, for example, income such as interest, dividends, and capital gains should not be subject to tax as long as that income remains in the account, making IRAs an attractive option for individuals saving for retirement.
Notwithstanding the general rule, profits that IRAs and tax-exempt organizations earn from certain types of investments may be subject to a special federal income tax known as the Unrelated Business Income Tax (UBIT). As its name implies, the UBIT applies to so-called unrelated business income—income derived from any regularly conducted “trade or business” that is not related to the tax-exempt organization’s “purpose” or “function.” A “trade or business” can include any activity conducted for the production of income from selling goods or performing services. Because the UBIT rules also apply to IRAs, if an IRA is invested in an income-producing business, then income from that business may be subject to the UBIT.
Congress introduced the UBIT in 1950 because, prior to its implementation, tax-exempt organizations had a competitive advantage over for-profit businesses. A tax-exempt organization could conduct unrelated business activities and retain the profits without incurring any income tax, so long as the level of business activity conducted was not so extensive that it caused the organization to lose its tax exemption. As a result of highly publicized incidents in which tax-exempt organizations carried out business activities in direct competition with for-profit businesses, Congress enacted a general tax on the “unrelated business income” of tax-exempt organizations.
Today, the UBIT applies to any unrelated business income exceeding $1,000 earned by tax-exempt organizations and IRAs—including traditional IRAs, Roth IRAs, Coverdell IRAs, simplified employee pensions (SEP-IRAs), and savings incentive match plans for employees (SIMPLE IRAs). The UBIT rules are broad and, as described above, generally apply to situations in which the IRA is operating a business. Additionally, if an IRA is a member of a partnership or limited liability company (LLC) that is conducting a business, then the income derived from that activity is also generally subject to the UBIT. The exceptions are payments of interest and dividends, which are generally carved out of the situations to which the UBIT might apply.
The UBIT also generally applies to income derived from debt-financed real estate. Income derived from real property purchased through debt is subject to UBIT for that portion of the income derived from the indebtedness. By contrast, an LLC that invests in pools of loans should not be treated as engaged in a trade or business subject to UBIT because only interest payments are involved as distributions.
Where the UBIT applies, the tax rate is equal to applicable corporate tax rates on the unrelated business income that exceeds $1,000. The IRA, not its owner, pays the UBIT. Additionally, if the IRA owner expects the IRA’s UBIT to equal or exceed $500, then the IRA must make estimated tax payments, which are generally due on a quarterly basis. An IRA (or a tax-exempt organization) subject to the UBIT must file Form 990-T and attach any required supporting schedules and forms.
For investors seeking to invest with Realty Mogul through their self-directed IRAs, the UBIT may apply to investments in equity opportunities—which is one reason why we discourage such usage. In Realty Mogul equity deals, the investor purchases shares of an LLC that, in turn, owns a share of a specific investment property that is usually partially financed by debt. In these situations, any profits over $1,000 from membership in the LLC are likely subject to the UBIT. Finally, as described above, if the IRA owner expects the IRA’s UBIT to equal or exceed $500, then the IRA must make estimated tax payments quarterly.
Realty Mogul debt investments, on the other hand, distribute only interest payments, and so do not produce the type of income that subjects IRAs to the UBIT. In Realty Mogul debt investments, investors do not own the property securing the loan; rather, investors simply earn monthly interest payments from the loan itself. Thus, IRAs invested in Realty Mogul debt securities should not produce unrelated business income that would incur UBIT.
Realty Mogul can (and regularly does) process investments made through a self-directed IRA account, although we do require that the IRA custodian be able to process documents via electronic signatures (we use DocuSign), and that it be able to process contributions and distributions via ACH transfer payments. Our debt investments should not generate unrelated business income that would subject IRAs to UBIT. As discussed above, however, we discourage the use of IRAs for equity investments because the subject properties are nearly always debt-financed and thus will cause the IRA to become subject to UBIT. If you are considering an IRA investment that may generate income subject to UBIT, you should consult your tax advisor in advance.
Realty Mogul offers equity securities through North Capital Private Securities, member FINRA/SIPC. Realty Mogul as an institution does not advise on any personal income tax requirements or issues. Use of any information from this article is for general information only and does not represent personal tax advice either express or implied. Readers are encouraged to seek professional tax advice for personal income tax questions and assistance.