At What Point Does UBIT Kick In For Leveraged LP Investments?

Question

Please don't respond to this with, "Ask an attorney or tax advisor."  That is a given...I want to solicit comments prior to that.

Scenario: Form a LP to raise money for real estate transactions and structure it so that it is capable of investing in a number of distressed assets, including commercial and residential properties in bulk.

Question:  When non-recourse debt is applied to leverage the LP funds invested the partnership could be considered a "business."  At what point does UDTI come into play for this type of a venture?  Is there a set of tests to determine whether or not the venture is suddenly "active" and thus subject to UDTI?  Our goal is to give the LP investors leverage without UDTI or UDFI tax if possible.  It is possible that certain types of activity could unravel the favorable tax treatment with a one-size-fits-all fund.

Investors: LP investors will be investing via a self-directed IRA entity and would ideally be able to take profits tax free. Investors could also be cash investors outside of a SDIRA entity, but the tax treatment here is clearer cut.

I have read articles on this and they are all very confusing to me.  The main article I found seemed to have circular references, but it did do a decent job of highlighting the litmus tests from the author's perspective.

Does anyone know if there is case law on this and/or guidance from the IRS via a private letter ruling of sorts?  I have read the IRS regs and they are far from helpful.

Account Closed · Answer

The IRS defines prohibited transactions fairly well.  The interpretation gets a little sticky.

Publication 598 discusses Unrelated business income as related to SDIRA, MSA, 401K

You will find these are all fairly general and to understand the details better means doing some tax research.  I'm by no means up-to-date on UBIT technical issues.

You start getting into very sketchy areas when SDIRA accounts are investing in partnerships.  This is an area that I don't touch.  It is a high liability area.  You will want to be well armed with facts and make sure that you discuss with a tax attorney that understands the case law.

Dave Toelkes · Answer

As long as the IRA is only a limited partner in the LP, I don't see any UBIT issues.  If the IRA owner is also a managing partner of the LP, then the investment in the LP itself could be a prohibited activity for the IRA.

This is a question best answered by an IRA custodian with full knowledge of the structure of the investment and the relationship between the LP managing partners and the investors.

William Johnson · Answer

If I understand correctly, you want to set up an LP where SDIRA and cash investors will fund the LP and then the LP will then leverage to buy properties.

From what I understand this would be permissable without UDFI.  There may be a problem if an individual SDIRA owns too high of a percentage of the LP or as a collection IRA own too much of the LP.

I think it could have have a problem if the total percentage of the money invested in the LP is IRA. The IRS may look at that as a sham way of having IRA leveraged without the tax.  E.g.  Only four people put in IRA money into the LP.  They are the only partners.  The LP leverages the money.  The IRS may not look kindly on that.  Now if the four investors are only a small fraction of the money involved, it may be permissable.

The above is mostly understanding the general intent of the IRS and not specific knowledge.  These would be my concerns.

No one could have both IRA and non-IRA money invested.

Bryan Hancock · Answer

Thanks Charles...I am hoping someone can point me to the case law.  The attorneys that specialize in this stuff bill out at like $1000/hour (yup...crazy) so I am doing my best to try to minimize the amount of time required with the attorney.

Are there any parts of the citation above that you feel are pertinent give what I have described?  Perhaps the "security for a loan" part.  I can't see this being the case if the LPs don't sign for recourse or for the carve-outs...right?

Bryan Hancock · Answer

I agree with the first part of your response Dave.  My understanding is that this is not subject to UBIT taxation if things are structured the "right way."  I haven't ever figured out what the right way is and I have since formed an entity (Delaware series LLC) with other partners where many of these issues were addressed by someone more experienced that I am.

Do you really think the IRA custodian would be qualified to make a call on the taxation?  I don't...but I don't talk to them all day long either.

Bryan Hancock · Answer

Any of you tax wizards have more information on this?

Bryan Hancock · Answer

The problem I am really trying to solve is to design the entity such that we can take advantage of the tax benefits to LPs (if possible) while allowing us to purchase as many different types of distressed assets as possible.  I don't want to have 2-3 passive investments that are contaminated by a single "active" investment later on such that they all are subject to UBIT (UBTI?) or UDFI once this transaction occurs.

If anyone knows of case law, private letter rulings, guidance, etc. on this I would love to see it  :mrgreen:

Jon Holdman · Answer

I'm with you, its extremely confusing.  And I have discussed it with my attorney and CPA.  I have an investment that's very much like this.  Its a mini-storage, and has about two thirds of the value in debt.  Its my understanding that income from this deal is subject to UBIT.  The debt financed fraction (0.67, roughly) is multiplied by my share of the income and that amount is subject to UBIT.  Unfortunately, this has been a poor investment and has yet to produce any positive income.  Since UBIT only kicks in after $1000 in UBIT (unrelated business taxable income), even a small amount of real income would not generate any tax.

Now, if the business is engaging in buying properties and flipping them, whether wholesale type flips or fix and flips, then the debt fraction doesn't come into play. Those are active businesses, and are 100% subject to UBIT regardless of the debt.

I'll admit I'm not sure what you mean by UDTI.  I know UBTI (unrelated business taxable income), UBIT (unrelated business income tax), and UDFI (unrelated debt financed income, the "exception to the exception" where rental income (normally an exception to UBIT) becomes taxable).  But UDTI?

The syndicator for this crummy mini-storage deal also says there is UBIT involved.  I'd be happy to pay a little UBIT in exchange for actually having some income.

At What Point Does UBIT Kick In For Leveraged LP Investments?

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