Most investment gains in a retirement account are exempt from federal income tax according to Code 408, and Section 512 of the Internal Revenue Code. Exempt income includes: rental income, interest income from loans, dividend income, capital gain income, annuities, royalties, and gains/losses from the sale of company stock. It’s a common misconception that all profits from transactions inside of an IRA are tax-free or tax-deferred; however, there are two types of taxes that can apply to income received by a retirement plan under certain circumstances. We get a lot of questions about this subject and we wanted to shed some light on the topic of Unrelated Business Income Tax (UBIT).
Unrelated business income is defined as income from “any unrelated trade or business…regularly carried on” (showing a frequency and continuity), that is not substantially related to the purposes of a retirement account. In other words, the retirement account’s investment must rise to the level of a trade or business, which is regularly carried on and is unrelated to its exempt purpose.
This may sound a little confusing so we’ll explain and give you some background. UBIT is a unique tax enacted by Congress in 1950 that applies to tax-exempt entities such as charities, churches, and universities. Congress was concerned with tax-exempt entities running a business and un-fairly competing against entities like corporations that pay taxes. This tax was later applied to retirement accounts as well and it comes into play in the case when an IRA owns and operates a business (e.g., restaurant, gas station, business selling goods or services, tech company). UBIT can affect IRAs as well as qualified plans and if UBIT tax is due the IRA owner must file a 990-T tax return for the IRA with the IRS and the IRA becomes responsible for the tax, not the account holder.
When an IRA receives ordinary income from an operating business, as opposed to what is considered passive income like rental income, from its investments then the IRA has to pay UBIT. Let’s explain: Passive income generated from investments like rental income, interest income, dividend income, capital gain income, and royalty income are exempt from UBIT. If, however, the account invests into an operating business (e.g. subway franchise) that is structured as a flow-through entity such as an LLC or LP, then UBIT would apply since the profits flow back to the investors. If the company is a C-Corp, UBIT would not apply as the corporation pays corporate income tax on the profits and then the income flows to the IRA as dividend income, which is exempt from UBIT tax. Note: income, dividends, or gains from a “C” Corporation, which makes up almost 99% of all public companies, such as Apple, Verizon, IBM, etc., eliminates the UBIT tax, which is why most Americans have not heard of this tax.
UBIT tax may also be due from any real estate activities that are short term and not passive in nature. For instance, rental income and capital gain income from the sale of property are exempt from UBIT, but there is a caveat. When the property is acquired with the immediate intent to sell then the income is not exempt from UBIT. So for example, if you are flipping properties and purchase one in your IRA with the immediate intent to flip it, then your account may have to pay UBIT. If however, you purchase the property with the intent to rent it and hold it long term then UBIT is not an issue. Also, if you sell one of your properties after holding it for one year or more than UBIT is not an issue either. Any time you hold property in an IRA or qualified plan on a short term basis like this it can be considered “inventory” just like if you were selling products or services through a business and it is treated the same way as far as UBIT is concerned. It all boils down to whether or not the property is held for investment or held for sale in the ordinary course of business. There are a lot of facts and circumstances to look at and more often than not there is not a line drawn in the sand.
Here are a few factors to look for when determining if UBIT may be due:
Was the property bought with the intent to immediately sell? This could be wholesaling or evening “flipping” meaning that the property is looked at as inventory.
2. Development Construction or Subdividing:
Land that is developed into new homes or buildings in a given period will likely be deemed an ordinary business activity.
3. Holding Time:
The longer the property is held, the more it is likely to be considered property held for investment purposes and not held as inventory. When a property is held for more than one year is considered a long term passive investment and anything less is short term in nature.
4. Number of Sales or Frequency of Similar Transactions:
If you complete a large number of transactions (flips, wholesales, development projects) in a short period of time there is a good chance that if the IRS looks at that transaction it will be considered a business transaction that is “regularly carried on” as opposed to holding for investment purposes.
It really boils down to the fact and circumstances involved in the transaction. Unfortunately, the IRS has only offered limited guidance on these factors. If you bought a property or two, rehabilitated them, and sold the houses within a year time because you received really great offers, this probably would not be considered selling real estate to customers in the ordinary course of business. If however, you flip 10 properties in a year inside your retirement account, this very likely would be considered running a business and is referred to as “dealer” status. The main issue here is the number of transactions conducted as this determines whether this is something done in the ordinary course of business or whether it is done for investment purposes. When in doubt run your transaction or transactions by a qualified attorney or CPA for an opinion.
There are certain types of investment income that are always exempt from UBIT, below is a list of exemptions from UBIT for your convenience:
Interest Income – Interest income, for instance as payment from a loan or promissory note that your IRA made is exempt from UBIT.
Dividend Income – This applies to dividends/profits from a C corporation (e.g., most publicly traded companies). Dividends from a Real Estate Investment Trust (REIT) are also considered exempt due to IRS Ruling 66-106.
Royalty Income – Certain intangible property that produces income, such as intellectual property like software licensing, publishing, patent licensing, or certain oil & gas and mineral leasing investments, etc.
Rental Income – Rental income from real property such as a rental property is exempt from UBIT tax.
Capital Gains – Capital gains from the sale, exchange, or disposition of an investment or real estate where the gain is realized when the asset is sold, except when the property is deemed to be “held primarily for sale to customers in the ordinary course of the trade or business.”
If you and your CPA or attorney come to the conclusion that UBIT is due, you must file IRS form 990-T on behalf of your IRA with the IRS by April 15th of the year following the year in which the Unrelated Business Income Tax was generated. An extension request can be filed for a three month extension using IRS Form 8868. The IRS only requires the 990-T to be filed when the income attributable to UBIT is over $1,000; anything below that and the 990-T does not need to be filed and no tax paid.
Below is the UBIT Tax Rate table for your convenience:
For any Self-Directed retirement investor looking to invest into alternative investments, it is wise to review the potential for UBIT with a qualified CPA or attorney because of the potential high tax involved when UBIT is triggered. The maximum tax rate of 39.6% is triggered at just $12,300 of income so determining this can be crucial. We hope this blog/article helped you understand UBIT when relating to retirement accounts, in the next blog/article we will discuss the Unrelated Debt Financed Income (UDFI) Tax that must be paid by a retirement account when the account takes on a loan and leverage is used.
Matthew A. Tillack
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