Unrelated Business Income Tax - UBIT for Solo 401(k) & IRA accounts June 26, 2008
Posted by Jeff Nabers in Self Directed IRA/401k, real estate.Tags: 401k, ira, leverage, mortgage, real estate, self directed, tax, taxation, taxes, UBIT, UBTI, UDFI, unrelated business income tax, unrelated business taxable income, unrelated debt financed income
trackback
If you talk to the average CPA, he’ll tell you that UBIT is the boogeyman and is to be avoided… always. Discussing this topic with an above average CPA (such as Eric Wikstrom of Integrated Wealth Strategies) yields different advice.
The Two Types of UBIT
- Triggered from a trade or business - if a tax exempt entity (such as an IRA or 401k) owns a trade or business, the income of that business is taxed at trust rates (i.e. very high tax rates). Both IRA & Solo 401k accounts are subject to this type of UBIT.
- Triggered from ownership of leveraged real estate - if a tax exempt entity (including IRA) owns real estate leveraged with a mortgage loan, the portion of that income attributable to the mortgage loan is taxed at trust rates. This type of UBIT is specifically referred to as UDFI - Unrelated Debt Financed Income. Solo 401k accounts & other qualified plans are exempt from UDFI.
Trust tax rates are very high, so it might make sense to avoid Type 1 UBIT at all costs. On the other hand, a close examination of UDFI tends to revoke its “boogeyman” status.
The reason UDFI isn’t a detrimental cost is that non-recourse mortgage loans (the only type an IRA/401k can legally obtain) are typically only offered at a 65% loan-to-value maximum. So this means that the UDFI tax is only payable on up to 65% of the property’s net income. (That’s right - net income. You do get to deduct depreciation and other expenses before paying UDFI tax).
Let’s examine a simple comparison of the taxes payable on net real estate income with 50% leverage:
Example A
| IRA | Individual | |
| Net Income | 10,000 | 10,000 |
| Tax Paid | 800 | 2,800 |
| Effective Tax Rate | 8.00% | 28.00% |
Example B
| IRA | Individual | |
| Net Income | 100,000 | 100,000 |
| Tax Paid | 16,229 | 28,000 |
| Effective Tax Rate | 16.23% | 28.00% |
The gap between the dollar amount of taxes paid widens as the income increases:
Let’s go back and look at Example B. Take the difference in taxes and examine the long term effects of 25 years of investing and compounding returns. These charts assume a 15% annualized ROI:
Example B1
This uses an effective tax rate of 16.23% for UDFI
Example B2
This uses an individual tax rate of 28%
The result? The IRA has a balance of $631,385.87 more than the individual does.
Conclusion
It might make sense to avoid Type 1 UBIT, while Type 2 UBIT (UDFI tax) results in less taxation than the alternative of investing with individual funds.
Feedburner Subscribe
How do you know by looking at K-1 if real estate is leveraged?
The most simple and direct way to handle investment of your plan funds into a partnership (such as an LLC) is to let the manager or general partner know up front that:
1. Your plan’s investment cannot carry any kind of guarantee for any loans of the partnership.
2. You must be notified each year of the details (amount) of any mortgage debt on real property owned by the partnership.
If I have an LLC funded by an IRA, and the LLC has income, and the LLC elected to be taxed as C corp, does that trigger UBTI?
@ Tom - Not only does having income taxed at the C Corp level not trigger UBIT… it would un-trigger UBIT if it would have been otherwise due because of the fact that you are paying Corp taxes.
The idea behind UBIT is that when tax exempt entities own businesses that produce income, they enjoy an unfair advantage over the normal taxable business. So UBIT is applied to level the playing field. If the tax exempt entity owns a C Corp, then it pays corporate taxes and their is no more unfair advantage to level out.
I have a defined benifit plan and want to purchase some S corp stock , Is that ok ? and I want the income (distributions) to go to my trust dbp. What would the tax rate be ? higher than the other shareholds or lower ?
John,
To be candid, I have little knowledge and experience with DB plans. For 97% of self directed investment situations they are not a good fit because contributions have to be the same every year. If the business has a bad year, the contributions must still be made. If the business has a good year, higher contributions cannot be made. Additionally, because of the actuarial work involved, they to cost 20x more per year in administrative fees to maintain than a Solo 401k.
Also, just as an FYI, there’s nothing that prohibits a retirement plan from purchasing stock in an S Corp. When that happens, however, the S Corp loses it’s S status and becomes a C Corp.
If you used a retirement plan to purchase membership units in an LLC taxed as a partnership, your UBTI tax would probably be much higher than the other shareholders.
If you used a retirement plan to purchase stock in a C Corp, UBIT would not be due because the Corporation would pay Corporate taxes.
Jeff
For a trading business, leverage is often greater than 10:1, so it seems that UDFI would be a big potential concern here. In the case of a properly formed LLC that is owned by a self-directed Roth IRA, where the LLC is a professional trading business that trades in leveraged instruments such as futures or spot currency, is UDFI or UBIT going to be triggered? If so, is there a better structure for the LLC other than to be owned by a Roth IRA?
Karl,
Firstly, if YOU run a business using your Roth IRA LLC it will be a prohibited transaction because YOU, a disqualified person, are running it
Secondly, if an IRA owns part of a business that is structured as an LLC taxed as a partnership (or any other pass through entity) UBIT will need to be paid on the entire net income of the business. Alternatively, if an IRA owns part of a business that is taxed as an entity (such as a C Corporation or an LLC taxed as a C Corporation) then UBIT does not need to be paid. UBIT is designed to remove an unfair advantage of a business not having to pay the income taxes that a competing business pays. So when that business is taxed as a corporation, then there is no unfair advantage that needs to be removed and thus no UBIT.
Your first sentence was “For a trading business, leverage is often greater than 10:1″. Make note that a trading business will trigger UBIT type #1 described in the post above, and, as said, there is a bigger problem if you run it.
You’ll probably find the best results in calling us to discuss so we can understand more about what you’re aiming to accomplish. We’re at 877-903-2220.
I have several clients who I perform financial planning for, who are interested in managed accounts for their IRA. One idea that I have is setting up a LLC, in which each IRA would own a percentage of the IRA. I would act as the manager of the IRA, and manage the investments held in the IRA. I would charge a fee based on the size of the IRA. Is this feasible?
@Russell - It is possible, yes. It sounds like you should have an registered investment adviser license. If you were an investment adviser representative (under an RIA company that isn’t run by you), then you would need to disclose ownership of LLCs to your supervisors.
Your question seems to be more of a securities regulation (SEC/NASD/FINRA) question; that’s not my area of expertise.