How to tell if what’s in a K-1 is UBIT and you must do a 990-T?

Question

I (my SDIRA) received a K-1 with “current year increase” of $2,749.  This is for a real estate syndication.  I was not expecting to be hit with UBIT until the end of this partnership, when equity is to be liquidated.  For now, it’s supposed to be all interest.  But my CPA says that I have to do a 990-T.  Could he be correct?

Part II of 1065:

G: Shows me as a “limited partner...”

H: “Domestic partner.”

I1: “IRA”

I2: Checked as a “retirement plan.”

J: All same from beginning to ending.

L: Shows the “current year increase” of $2,749; “tax basis” is checked.

M: “No” is checked.

Part III:

1. $2,749 income.

5. $13 in interest income.

20. “A”; $13

20. “Z”; $2,736

(no other box in Part III is used.)

Supplemental information for the 1065 states:

“CLASSIFICATION OF INCOME AS PASSIVE OR NON PASSIVE AS IT APPLIES TO THE IRC SEC. 1411 NET INVESTMENT INCOME TAX MUST BE DETERMINED FOR EACH INDIVIDUAL PARTNER. PLEASE CONTACT YOUR TAX ADVISOR FOR ASSISTANCE WITH THIS CLASSIFICATION.”

Of potential additional interest may be a note in Form 568:

“LINE 20C - COLUMN D

OTHER INFORMATION

PROPORTIONATE INT. OF AGGREGATE GROSS RECEIPTS..............................$ 24,708.

TOTAL $ 24,708.”

Any professional help is appreciated.

Jeremiah Mon · Answer

@Lane Kawaoka Thanks for the thorough response!

This is NOT legal or professional advice.

SITUATION

• My issue with SDIRAs is the tremendous amount of UBIT tax that the investor has to pay. "39.6% after just $12,400 of income subject to UBIT"That is a hefty amount of tax rate for just a small net income
• "39.6% after just $12,400 of income subject to UBIT"
• That is a hefty amount of tax rate for just a small net income
• It's become difficult for me to advise my investors to invest with their retirement funds due to these UBIT taxes, at least for now till I get more information.

• "39.6% after just $12,400 of income subject to UBIT"
• That is a hefty amount of tax rate for just a small net income

BACKGROUND

• SDIRA's have become very popular as of late due to the tremendous amount of capital available in that space (trillions)
• Many Sponsors often advise their investors to invest their retirement funds into their syndications via SDIRA to "diversify" their portfolio from just stocks/bonds/mutual funds from their IRA/401k

ASSESSMENT

• I don't think many passive investors are educated enough about UBIT/UDFI taxes and how big of an impact it is to their ROI
• Tom Wheelwright in a podcast has mentioned using a Solo 401k instead of SDIRA to help lower some of the taxes you have to pay. Similar to you answer above." The solo 401(k) is not subject to UDFI but it subject to UBIT. The IRAs are all subject to UBIT and UDFI. Note that generally the passive income flowing back to you is very low and the as a result we don't see a huge UBIT tax."
• " The solo 401(k) is not subject to UDFI but it subject to UBIT. The IRAs are all subject to UBIT and UDFI. Note that generally the passive income flowing back to you is very low and the as a result we don't see a huge UBIT tax."

• " The solo 401(k) is not subject to UDFI but it subject to UBIT. The IRAs are all subject to UBIT and UDFI. Note that generally the passive income flowing back to you is very low and the as a result we don't see a huge UBIT tax."

RECOMMENDATION

• This is not legal and professional advice, and you should always consult with your CPA/accountant/financial advisor, etc. 
• I think it's important to educate ourselves as the Sponsors, so that we can advocate for our passive investors who have worked so hard for their money. 
• Id like to see a numbers comparison of UBIT taxes using an SDIRA vs solo 401k in a real estate syndication. I think seeing is believing and would definitely help out those who are willing to invest their retirement funds into real estate syndications.

Lane Kawaoka · Answer

Answer [Note: From CPA and not this is NOT legal or professional advice]: When you invest in a business (syndicate = business) with your IRA, the IRA will be subject to UBIT (unrelated business income tax) and UDFI (unrelated debt financed income).

For our purposes, UDFI is produced when an IRA uses debt to purchase real estate. Essentially, the portion of the property’s income considered UDFI is based on the percentage of rental income derived from debt.

For example, Property A is purchased for $100,000. You put down 25% of the purchase price as a down payment and finance the remaining 75% with a traditional mortgage from the bank. The property produces $10,000 in net income for the year. $7,500 (75%) of the net income is considered UDFI and is subject to UBIT.

There is a deduction for the first $1,000 of income subject to UBIT. Income subject to UBIT over $1,000 is taxed at trust rates. For 2017, trust tax rates start at 15% and max out at 39.6% after just $12,400 of income subject to UBIT.

UBIT is paid by the IRA account. If for whatever reason UBIT is paid directly by the taxpayer, the amount paid is considered a contribution to the IRA.

Follow up question: Is there any difference in how the UDFI will apply for these:

1) SD IRA

2) SEP-IRA

3) Solo 401K

4) SD IRA (operated as an LLC) so this one is confusing... My LLC owns an LLC (syndication) which owns a property

I’m trying to decide if one is better than another for tax purposes.

Answer: The solo 401(k) is not subject to UDFI but it subject to UBIT. The IRAs are all subject to UBIT and UDFI. Note that generally the passive income flowing back to you is very low and the as a result we don't see a huge UBIT tax.

Another idea would be to take a debt position (lending) rather than equity. The interest you would receive is free of UBIT and UDFI tax.

(This suggestion of a "debt" position or note investment with the SEP IRA to avoid UBIT and UDFI tax is a creative one... but it’s a very low chance of happening because it’s just too complicated and honestly not worth the effort from the syndicators side. It’s a very similar case of to a Tenant-In-Common (TIC) arrangement where an investor has 1031 exchange funds and wants to parlay that money into a syndication. It’s possible but from the syndicator’s prospective a lot of unneeded work when you can just raise the funds the traditional way. Caveat: if you are bringing in a huge amount of money say 50% of the raise then that might tip the scales in your favor)

Ask you can tell this is a really grey area. One CPA mentioned, the answer depends on how you structured the syndication, UBIT may or may not apply for the real estate holding for solo 401k. I would really try to toss the Operation Agreement to your individual CPAs to examine and determine ahead of time.

Eamonn McElroy · Answer

Box 20V is UBTI.

It would appear your investment did not generate UBTI based on what you've laid out, but that is hard to believe if you have ordinary business income in Box 1...

Carl Fischer · Answer

@Al D.

If your Ira is an owner of an operating business and receiving payments as an owner then it could be subject to UBIT.  Do you get more money if the company makes more money in the project? If yes- you probably should file 990T. You said there was no debt on the business- if true then you have no UDFI.

Basit Siddiqi · Answer

@Al D.

Whether the partnership income is UBTI or not it determined at the partnership level. This information is then provided to its investors(partners/members).@Eamonn McElroy kindly provided information on where to find UBTI details on the K-1.

Al D. · Answer

@Eamonn McElroy The syndication purchased land, entitled, and is currently building SFRs for sale.  There is no leverage - only money from partners and, as sales occur, some of that money gets put back into subsequent construction.  During each of these phases, there is supposed to be annual interest paid to each partner.  At the end, when all SFRs are sold, there will also be a share in the profit (I presume this would be subject to UBIT.)

So, is the burden to make it clear whether or not the 2018 “income” in this K-1 is subject to UBIT for my SDIRA on the partnership’s CPA/accountant?  I can’t imagine that just the fact that the income is over $1,000 - without clearly being UBTI - is enough for my CPA to say that I must file a 990T.  I mean, I get the “playing it safe” aspect, but there has got to be a way to tell whether the income is UBTI, which is the second (and indelible) part of necessity for a 990T, as I understand it.

Basit Siddiqi · Answer

@Al D.990-t is required to be filed by exempt entities if the UBTI is $1,000 or greater.

Eamonn McElroy · Answer

Why was the taxable income reported in box 1 for a real estate syndication by the way?  What does the syndication do?

How to tell if what’s in a K-1 is UBIT and you must do a 990-T?

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