Should I be worried about the UBIT / UBTI tax and an SDIRA?

Question

Hi All,

I am interested in transferring funds from my IRA held at a brokerage firm to a SDIRA with a custodian. I've done my homework on SDIRAs and I am aware of the benefits and the restrictions. However, my tax attorney is advising me against it due to the possibility of the UBIT / UBTI tax being triggered. So far, it is not a risk. But, if it is triggered it looks like it could be painful

Can anyone shed some more light on this? Has anyone opted out of this investing strategy due to this possibility? Here is an article from Forbes that explains in detail the risk:

https://www.forbes.com/sites/greatspeculations/2015/07/15/beware-unintended-tax-consequences-of-unrelated-business-income/#7b6970f926b7

Brian Eastman · Answer

@Nathan Williams

One needs to be aware of, but not necessarily worried by, UBIT and UDFI.

UBIT can be a deal-killer and in most cases should be avoided.  This tax applies when a tax-exempt entity engages in a trade or business on a regular or repeated basis.  Passive income such as interest, dividends, royalties, rent from real property, or the sale of an asset that has been held to produce passive income over time are not subject to UBIT.  Things like flipping houses or new home development can be subject to UBIT.

UDFI is not generally a big concern.  This tax applied to a tax-exempt retirement plan when it uses leverage.  The percentage of the income attributed to the non-IRA (borrowed) funds is taxed.  The tax impact is generally low, and should not outweigh the benefits of leverage in terms of generating higher cash-on-cash return.  Solo 401(k) plans are exempted from UDFI when the debt is secured by real property.

At the end of the day, pursuing a self-directed retirement plan and alternative asset investing makes sense if you can produce better results for the retirement plan - both in terms of security of the underlying assets and the income produced.  There are a lot of ways to do this that do not involve UBIT taxation, and where the bite of UDFI taxation is less than the net positive return from leverage.

Brian Eastman · Answer

@David Goings

I would be concerned with both the flipping nature of the deals, which is a trade or business and therefore subject to UBIT, as well as the frequent joint venturing between your own personal business and the IRA.  I would also rely on the guidance of a CPA over that of a custodian.  Custodians are specifically not going to provide tax or legal advice - and yet their un-trained customer service staff do it all the time out of the temptation to want to be "helpful".

George Blower · Answer

@Nathan Williams

UBIT and UDFI does apply to retirement accounts but it depends on the situation and the type of account (solo 401k vs IRA, for example).

• For IRAs, both UBIT and UDFI  applies.

• For solo 401(k) plans, only UBIT applies. 
• https://www.irs.gov/charities-non-profits/unrelated-business-income-tax
• https://www.irs.gov/irm/part7/irm_07-027-008

UBIT

Unrelated business income tax applies to IRAs and solo 401(k) plans that invest by way of equity in a business that offers goods or services. The purpose of unrelated business income tax is to even the playing field between those investors that don't use retirement funds versus those  that due to invest in a business that offers goods or services (e.g., a shoe store, or a business that flips real estate).

UDFI

On the other hand, unrelated debt financing tax only applies to an IRA that incorporates debt financing for investing in real estate. This tax does not currently apply to 401(k) plans including self-employed solo 401(k) plans.

Dmitriy Fomichenko · Answer

Hello Nathan,

As long as you make passive investments and don't use debt financing on investment property - UBIT will not apply. What kind of investments do you intent to make with your SDIRA?

Dmitriy Fomichenko · Answer

@David Goings,

Retirement accounts are designed to passively build wealth for retirement. As long as you invest your IRA funds in passive investments - all income and gains from such investments would be sheltered from taxation until distribution or in a case of a Roth IRA/Roth 401k - tax free.

Income and gains from investments that are not passive will be subject to UBIT, the IRA is responsible for paying this tax. Then at the time of distribution - account holder will be paying ordinary income tax. This is not very smart and cuts into your profit. In some instances if the returns are high - it might make sense, but generally speaking IRA should only invest in passive investments.

The second, and the most important question here is the fact that your LLC partnered with your IRA (both yourself and your LLC are considered to be "disqualified" in relation to your IRA). The IRS rules forbid and direct or indirect benefit to you from your retirement account. The IRS rules also forbid you from providing any services to your IRA. Once you get into the mix with your IRA - the burden is on you as the tax payer to prove you did not receive any personal benefits from the IRA and that the IRA did not benefit from you personally.

In your situation I think it's pretty obvious that your IRA gained some benefit as a result of your personal involvement. I don't think you will be able to stand under the scrutiny of the DOL or the IRS. My recommendation to you is to cease engaging in any transaction with your IRA, either personally or through your LLC, go hire an ERISA attorney who can take a closer look at your transactions and provide you with fiduciary advice.

Do not rely on the guidance you get from customer service rep. of your custodian, many of them are under-trained and ignorant of the rules. Plus they don't take any responsibility for what you do with your IRA. If you review your customer agreement you will find that waive any and all liability for any transactions in your IRA. The point is this - you personally must understand the prohibited transaction rules, and one of the basic ones is your involvement as disqualified person, and if something is unclear seek professional guidance.

Brian Eastman · Answer

@Charles Soper

One flip will not necessarily subject a 401k to UBIT.  A tax exempt entity (IRA, 401(k), non-profit, etc) is subject to UBIT when it engages in a trade or business on a regular or repeated basis.  Rather than being an insidious tax, UBIT is a long standing means to protect tax-paying businesses from unfair competition.  If we let tax-exempt entities compete directly with tax-paying businesses, we would have no tax-paying businesses left.

It is possible to use various strategies to convert an activity in a plan to a subsidary entity that pays corporate taxes.  This was not particularly beneficial when the difference between UBIT trust taxes and Corporate taxes was only 4 percent.  I am sure there will be some work in the legal community to standardize some of these strategies now that there is an 18% differential between the two taxes.

George Blower · Answer

@David Goings

It appears that UDFI applies since debt financing was used.

Charles Soper · Answer

So how would one go about using solo 401(k) funds to flip properties while minimizing the UBIT hit?  From above one okay flip would put the gross income over $12k and subject your 401(k) to an over 40% tax hit.  Does the new 20% tax pass-through help out here and max that number out?  Seems like a insidious tax for the unaware!

Steven Hamilton II · Answer

Nathan,

It is a common occurrence to do so. What types of investments are you looking at doing in your IRA?

Should I be worried about the UBIT / UBTI tax and an SDIRA?

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