At this point we understand the tax advantages of SDIRAs.  The problem is that there is often confusion about SDIRA tax rules.  Compounding the issue is that the majority of CPAs don’t understand the complexity associated with them.  It’s not that CPAs are naive to the issues; it is just that they are not faced with them on a daily basis in their practices.

Many people believe that an SDIRA can invest in virtually anything without incurring any tax consequences.  Unfortunately, this is just not the case.  Although an SDIRA can invest in most assets, certain investments may trigger immediate tax issues.  This is where the complexity lies.

The two main issues for SDIRAs relate to income from a trade or business that is regularly carried on (this can be directly or indirectly) or income generated from debt-financed property.  These issues are identified herein as: (1) unrelated business taxable income (“UBIT”); and (2) unrelated debt-financed income (“UDFI”). It is critical for SDIRAs to understand these issues and to determine when they trigger a tax filing requirement.

One of the reasons why understanding UBIT and UDFI is so important is that the tax rates can be high.   IRAs are taxed at trust rates. However, they are not allowed to claim the deduction for an exemption that is normally allowed to a trust.

Unrelated Business Income Tax

UBIT may seem unfair or counterintuitive.  It was established as a way to tax non-profit entities that engaged in business activities that were unrelated to their charitable purpose.  UBIT essentially provides a level playing field whereby both exempt entities are taxed on unrelated business income just like private for-profit entities.  When retirement accounts were established many years back, Congress essentially extended these rules to certain retirement accounts to further provide a way to distinguish tax attributes and allow for a level playing field between exempt and for-profit entities.

Before we take a closer look at the tax issues relating to UBIT, let’s first examine what income is excluded from UBIT:

Interest income.  This would include payments made under loans, bonds, and other similar instruments.  The payments are considered to be from the securities loaned and not from collateral security or the investment of collateral security from the loans. Payments with respect to securities loans include: (a) interest and other distributions made; (b) fees paid that are based on the period of time the loan is in effect and the fair market value of the security; (c) income from collateral security for the loan; and (d) income from the investment of collateral security.

Dividend income.  This typically includes dividends from a C corporation or qualified dividends from a real estate investment trust.

Royalty income.  This generally includes income relating to intangible property and certain oil and gas activities.  To be considered a royalty, the payment itself must relate to the use of a valuable right.  Payments made for trade names, trademarks, or copyrights are generally considered royalties. Additionally, payments for the use of a professional athlete’s name, photograph, or facsimile signature are generally considered royalties. However, royalties will not include any payments made associated with personal services performed. Accordingly, payments for personal appearances or interviews would be considered personal services and are not excluded as royalties.

Rental income.  Rents from real property are excluded from the computation of UBIT. Rents from personal property are not excluded. However, special rules apply to “mixed leases” of both real and personal property, and, of course, UDFI needs to be considered.

Capital gains.  Capital gains from the sale, exchange, or disposition of property are exempt.  However, this is not the case for property held primarily for sale to customers in the normal course of business.  Additionally, capital gains may be taxable in transactions subject to UDFI.

UBIT is generally defined as the gross income derived from any unrelated trade or business regularly conducted by the exempt organization, less any deductions associated with carrying on the trade.  The business or trade itself needs to be “regularly carried on” in order to trigger UBIT. Should an organization regularly engage in two or more unrelated business activities, its unrelated business taxable income is the total of gross income from all such activities, less the total allowable deductions attributable to all activities.  In most situations, UBIT occurs when an SDIRA owns a portion of an operating business (retail store, service business, etc).

Unrelated Debt-Financed Income

UDFI is another issue that warrants consideration.  It is generally defined as any property held to produce income for which there is acquisition indebtedness at any time during the tax year.  It also includes gains from the disposition of such property.  UDFI applies to corporate stock, tangible personal property, and, more importantly, real estate.

UDFI will only apply to income that is generated from debt financing.  This would include rental income and capital gains, two types of income that are normally exempt from UBIT.  UDFI is applied to debt-financed property in which there is acquisition indebtedness.  In general, the term “debt-financed property” means any property held to produce income (including gain from its disposition) for which there is an acquisition indebtedness at any time during the tax year (or during the 12-month period before the date of the property’s disposal, if it was disposed of during the tax year). Acquisition indebtedness refers to debt used to acquire or substantially improve property, as well as any debt financing incurred prior to the actual acquisition, if the intent was to facilitate the acquisition.    

Extending, renewing, or refinancing an existing debt is considered a continuation of that debt to the extent its outstanding principal does not increase. When the principal of the modified debt is more than the outstanding principal of the old debt, the excess is treated as a separate debt.  In general, any modification or substitution of the terms of a debt by an organization is considered an extension or renewal of the original debt, rather than the start of a new one, to the extent that the outstanding principal of the debt does not increase.

What this means in practice is that if your SDIRA acquires a rental home for $200,000 with a $50,000 down payment and obtains a $150,000 loan to finance the purchase, approximately 75% of the income generated by the property would be subject to UDFI.  The UDFI calculation is actually a little more complex.  It is calculated as the percentage of average acquisition indebtedness for a tax year divided by the property’s average adjusted basis for the year (average debt/average basis).  It is a typical real estate holding; the basis in the property will decrease each year, and the mortgage balance will decrease as a result of the amortization of principal payments.

So, using the example above, let’s calculate UDFI for a given year:

·       the net income for the property was $10,000 for the year;

·       the beginning debt balance was $150,000, and the ending debt balance was $140,000, resulting in an average debt balance of $145,000;

·       the beginning basis in the property was $200,000, and the ending basis in the property was $190,000, resulting in an average basis of $195,000

First, we divide the average debt of $145,000 by the average basis of $195,000.  The result is .744.  We would then multiply this number by the net income of $10,000, resulting in $7,440 of taxable income.

As a result of depreciation, many SDIRAs will be subject to minimal (if any) UDFI in a given year.  However, as previously discussed, capital gains on the disposition of debt-financed real estate are subject to UDFI.  This can result in a substantial tax liability that many folks are unaware of.

A Closer Look at Real Estate Activities

Since real estate is one of the favored assets for SDIRAs, we should examine specific tax issues more closely.  We have already established that UBIT is generally defined as the gross income derived from any unrelated trade or business regularly conducted by the exempt organization.  People who buy and sell (or “flip”) real properties often refer to themselves as real estate “investors” and assume they have no UBIT issues.  But UBIT would be applied to an entity that regularly conducts a trade or business.  Accordingly, is the SDIRA operating an active trade or business, or is it acting as an investor?  If the SDIRA is determined to be acting as a trade or business, this is often referred to as “dealer” status and would be subject to UBIT, whereas a mere investor would typically not.

Determining dealer status is often difficult.  If the IRA buys and sells properties on a daily basis, then the IRS may take the position that this is a business activity.  For example, this would be similar to a CPA who charges clients a fee for their services.  If the CPA occasionally undertakes a real estate deal, then they could be more easily considered an investor, as this activity is not necessarily part of a normal trade.

While it is certainly a subjective issue, the IRS will often look to the specific “intent” of the taxpayer.  Specifically, the following criteria are often examined:

• The purpose for which the original acquisition was made
• Duration of ownership and the purpose for which it was sold
• Frequency and continuity of sales
• The extent to which improvements (if any) were made to the property
• Control and effort expended by the taxpayer in the sales process
• Use of real estate brokers and the extent of advertising initiatives
• Ordinary business and experience of the taxpayer
• Nature of the taxpayer’s other real estate holdings
• Income from the sale compared to other sources of income and employment
• Reluctance or desire to dispose of the property

Considering the above criteria, one of the most important issues appears to be the volume, frequency, and consistency of real estate sales. Said differently, if there is a history of selling a large number of properties and no other activities, then this may weigh in favor of dealer status.  However, just because the IRA may have dealer status with respect to a property or certain properties, it does not necessarily mean it is a dealer on all properties.  Accordingly, having a formal structure in place may enable the IRS to view the taxpayer’s investment intent favorably.

But there are other real estate activities that should be considered.  An IRA may also issue or acquire a note as part of a debt deal.  The IRA typically holds an interest in a promissory note issued for short-term financing of a real estate project.  Investors in debt deals typically do not participate in any upside in the property and are merely acting as investors.  Any payments they receive are typically classified as interest income and, accordingly, not subject to UBIT.

Real property held for long-term rental purposes only typically qualifies under the UBIT exemption.  However, there still may be an issue with UDFI.  A long-term acquisition of land by an IRA would also not be subject to UBIT, as long as it did not escalate to dealer status, as previously discussed.

Strategies to Avoid UBIT & UDFI

Any SDIRA should try to avoid UBIT or UDFI whenever possible.  Below are a few strategies that can be implemented:

Avoid Debt.  This of course, is obvious, but make sure to consider having any real estate holdings with debt held outside of an IRA.  Additionally, you may want to consider an all-cash purchase.  To effect this transaction, you may want to consider converting a potential debt holder into an equity interest.  For example, if an SDIRA were acquiring a property for $100,000 and planning to use $40,000 from the IRA, while using a loan of $60,000 from a financial institution or another real estate investor, the transaction would be subject to UDFI. However, if the $60,000 loan is considered an equity investment, then UDFI is not an issue. An LLC could be formed to accomplish this transaction, whereby the investors will own a percentage of the membership units of the LLC.

Blocker Corporation.  If UBIT is a concern, the SDIRA could consider setting up a blocker corporation.  The IRA would invest in a 100% owned C Corporation.  The C Corporation would then invest in an operating business.  The IRA would merely own the shares of the corporation, and all the profits of the operations would be taxed at the corporate tax rate.  The IRA can then take a dividend payment from the corporation and, accordingly, would avoid UBIT.  Since this transaction generates tax at the C Corporation level, it needs to be carefully reviewed by a CPA prior to implementation to ensure that tax implications are thoroughly considered.  

Pay off debt prior to sale.  Another strategy to avoid UDFI is to consider paying off the debt prior to the sale.  UDFI tax upon the sale of a property is calculated by taking the average debt balance.  But if there is no debt over the 12-month period prior to the sale, then no UDFI tax would apply upon disposition.

Sale of LLC shares.  When an IRA owns membership units in an LLC and the LLC owns real estate with debt financing, UDFI tax will still be applicable, as the LLC is a flow-through entity of the SDIRA.  However, to avoid UDFI, the SDIRA could consider selling its LLC shares to a prospective buyer rather than the real estate itself.  The SDIRA would then have capital gains on the disposition of the LLC units, which would not be subject to UDFI.

In summary, there are several steps an SDIRA can take to avoid or mitigate issues associated with UBIT or UDFI.  Ensure that any strategy is carefully reviewed by a qualified professional.

Tax Filing?

So what are the tax filing requirements if you have UBIT or UDFI?  First, a filing is only required if there is gross income of $1,000 or more.  Gross income is defined as gross receipts minus the cost of goods sold.  Assuming this criterion is met, Form 990-T, Exempt Organization Business Income Tax Return, must be filed and the tax paid accordingly.  As previously discussed, tax rates can be high because IRAs are taxed at trust rates. However, they are not allowed to claim the deduction for an exemption that is normally allowed to a trust.

If you are unable to meet the April 15th deadline, you may file for a 3-month extension utilizing IRS Form 8868.  However, it is essential to recognize that an extension is only an extension of time to file, not to pay.  If a payment is not made in a timely manner, penalties and interest will be incurred.

Even if no tax is due, it may be a good idea to file a tax return so that any capital gains from the ultimate sale of the real estate (which is also partially taxable due to the debt financing) are offset by any carryover losses that have been generated over the years.

Bottom Line

So just because an SDIRA can invest in almost anything, you must consider any immediate tax consequences.  UBIT and UDFI are especially important considerations when it comes to real estate transactions.  UDFI is often overlooked and can pose a problem for rental properties with debt financing.  Before you consummate any real estate transaction, make sure that you review the tax consequences and filing requirements with your CPA or tax professional.