EP 17 – When Does Your IRA Have to Pay Taxes? UBIT and UDFI Explained

Mark and Mat explain the two taxes that can apply to your IRA or other retirement accounts. These taxes, Unrelated Business Income Tax “UBIT” and Unrelated Debt-Financed Income Tax “UDFI” are the two taxes that can apply to your retirement account. They explain how they apply and the strategies on how to minimize or avoid them.​
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Mark Kohler: Welcome, everybody, to this week’s episode of the Directed IRA podcast. My name is Mark Kohler and I’m here with my illustrious co-host, the one and only Mat Sorensen,  the Adopt a Child, the prodigy of self-directing in the United States, I can’t say the father because it’s been around a while.

Mat Sorensen: But yeah, you’re like the next best thing to. Yeah, yeah. I like illustrious. You could have just ended there. I mean illustrious. Nothing else added to it. That’s what I don’t even know what illustrious means. I just know it sounds really cool. Yeah.

Mark Kohler: You’re illustrating. Oh yeah. Welcome everybody. This is a great topic today excited to have you all here. We take turns introducing the show. So obviously this is the more exciting introduction to my ear versus I’m the color commentary. While, Mat is the brains behind the operation.

Mat Sorensen: Yeah, but what Mark likes to say is he’s the interesting one. I’m the boring one.

Mark Kohler: That’s the words. If the shoe fits, you know, I’m not I’m not going to say anything more, but I’m apparently not illustrious. Ok, well, if you if you bounced into this podcast wondering what the heck these guys are about, although the joking and the kidding aside, we are trying to be the foremost experts on self-directing in the country or both tax attorneys, officers in the national company known as Directed IRA under the direct trust company platform. It’s legit. We’re legit trying to be lit and legit trying to trying to relate to our younger crowd.

Mat Sorensen: But anyway, yeah, that’s what the younger crowd now they’re like they want to be a crypto with their IRAs and stuff. And so we do get the younger crowd now. So we’re trying to get the lingo down. I thought you were going to go too legit to quit that one. Oh, that’s a different crowd. That’s more of our stand by traditional crowd. That would appreciate that. I think of that too legit to quit.

Mark Kohler: On YouTube. You’ve got to see Mat do that. Yes. We’re here on Spotify, YouTube, Stitcher and iTunes, as well as various other platforms for podcasting. We have over a million downloads between the two or three podcasts we’ve done over the last ten years. This is our newest podcast platform because we just had to dedicate a show to Self-directing because just to demand so many questions, so many topics. And today this is actually going to be probably a little shorter podcast. And it’s we’re going try to keep it lively with some good examples. But it’s straight to the point. It is the unrelated business tax or UBIT tax or unrelated business income tax. UDFI tax this kind of crappy but you got to know about. It’s kind of like just got to know what’s a good analogy.

Mat Sorensen: Yeah, it’s like the, you know, the rules of the game. You just got to know the rules. You might not like them, but you know the rules. And, you know, like, you know, if it’s if you’re golfing, you want to know you don’t want to hit in the sand. If you’re self-directing, you know, you don’t want to run into UBIT. OK, same thing.

Mark Kohler: Or as some of us may have done in high school, if you don’t want to roll the golf course, a golf cart, I mean, that would be.

Mat Sorensen: That’s also bad too.

Mark Kohler: Say on this golf course for life that could happen. I understand those details. Yeah. I mean, you don’t know. Yeah,

Mat Sorensen: It’s attorney-client privilege. I won’t I won’t divulge anything that I know on that’s on the subject.

Mark Kohler: Those records have been expunged because I was a minor sorry that a friend of mine was a minor. But anyway,

Mat Sorensen: OK, well let’s these two four-letter words, UBIT unrelated business income tax. It’s called UBTI, unrelated to business taxable income. But we refer to as UBIT as the tax itself and then you DFI unrelated finance income. These are the two weird taxes your IRA can get caught up in. Now, it’s not the end of the world if you have it. It’s not like a primitive transaction that could disqualify the account. It’s just a tax that when you make money from one hitting into one of these areas, the IRS now wants you to pay some tax on the income. Remember, when you’re using a retirement account in general, you know, you’re getting rental income or you sell an asset for profit, you get a capital gain or any interest income on it. No, all this is going to the retirement account. You don’t pay tax, right? It’s building up tax deferred and a traditional are going to come out tax free in a Roth. But you get to keep all that money and reinvest everything into the next investment. But UBIT and UDFI are the one caveat to that, where you can get hit with tax and the IRA ends up paying tax and filing its own tax return called the 990-T to the IRS, which is no fun.

Mark Kohler: And even a Roth can end up paying this tax now. Here’s what I propose. Let me take a stab at explaining with an example that a quick definition of what UBIT would look like and then you take a stab at UDFI, which is a derivative of you that technically, but they really are two different taxes. What do you think? Can you take the challenge? My fine, sir.

Mat Sorensen: I love a challenge accepted.

Mark Kohler: OK. So UBIT, folks.

Mat Sorensen: So, if you like like if you ever want to say I accept the challenge, say, what was the challenge you accepted today? Well, I agreed to throw down on unrelated debt financed income while the other guy had to explain to unrelated business income tax collection. Oh, OK.

Mark Kohler: So you might say, OK, a daily occurrence for me. OK, so I’ve actually got a really fun story that’s probably a little too long for this podcast that I tell about a spaghetti factory, pasta factory to be more technical in New York that went all the way to the Supreme Court regarding UBIT. So this is a fairly important issue that has been litigated for almost one hundred years. And what it’s about is leveling the playing field whenever a nonprofit is going to go play in the business world, not just invest, but play in the business world. We as a society through Congress have said, you know what, they got to pay their fair share tax because it’s not fair to the regular John Doe, Mary Jones that they’ve got. They’ve got to keep it fair. So, UBIT is that thing, whether it’s a non-profit charitable entity or an IRA or a Roth or a 401K, that basic concept if you can all remember this, you don’t get to chapped, is we’re leveling the playing field. And so what it means is if my retirement accounts say retirement account taking all these different types into one big group, if my retirement account goes out and buys a piece of land, sits on it and sells it, that’s capital gain. That’s passive tax, it’s investment. But if my retirement account goes out and buys a restaurant. And makes money in that restaurant, it needs to pay its fair share of tax so the other restaurants in town don’t get undercut by the pricing of this other restaurant that’s owned by a retirement account who in effect, could charge less for a chicken fried steak platter because they’re not paying taxes and Cracker Barrel across town is going. That’s not fair. We’ve got to charge more because we have to pay tax. So they’re trying to level the playing field. And since I love Cracker Barrel, I had to bring in an example such as that. So a retirement account pays this tax called UBIT when it’s competing in an operational business against other operational businesses. The tax rate, though, is a problem. It’s 37%, which is terrible. So in a moment, we’ll talk about how to limit that to a much lower reasonable rate. But you beat tax applies when you’re competing in an operational business, are you?

Mat Sorensen: Yeah, I think the one way I break that down is investment income in an IRA. See, retirement accounts are designed to receive investment income like rental income, capital gain, income, interest income, dividend income. When you get that an IRA, don’t worry, you don’t pay tax on that. That’s what retirement accounts are designed to get investment income. But if you get business income, unrelated business income tax applies like Mark said.

Mat Sorensen: So so operational businesses like let’s say you’re using your IRA to do a real estate development or you flip a ton of houses not just a couple of year like you’re flipping a lot of properties or you’re doing crypto mining. Know, these are the things where we see clients using IRAs, but they’re more in the business of things, not just investing. All right. Now, let’s get that strategy, though, because the rate is 37%.

Mark Kohler: And I don’t know that you’re already screwing up the challenge. Your job is to explain UDFI.

Mat Sorensen: Oh, you wanted to do that. Let’s do that. Don’t want to get it for UDFI, because I’ll kind doesn’t help with UDFI.

Mark Kohler: If you’re scared to take the challenge you want to punt. That’s fine. That’s fine. And I’m not opposed to that.

Mat Sorensen: OK, actually I’m going to, I’m going to wait because I to get the blocker out of the way.

Mark Kohler: Yeah. Now and OK. And on that note, let me say this, if we’re going to vet UBIT for one moment before you explain how to limit it, but I like what you just said there, if I may Mat is what are some examples where UBIT would apply the restaurant? Is it OK for an IRA or for one to own a restaurant? Sure, sure. Just pay your fair share tax to level the playing field. Can you mind crypto? Yes. Can you own cattle? Yes. Could you rent an RV? Yes. What else?

Mat Sorensen: Can you flip ten houses a year with your IRA. Yeah. Yes. But subject you to a real estate development. Yes.

Mark Kohler: Condo conversion, online, online marketing. A click funnel. Amazon affiliate. All this can be done, Import-Export with Roth or else a Roth or 401k retirement account. You just tax more deal.

Mat Sorensen: He’s an importer-exporter,

Mark Kohler: Vandalay indutries.

Mat Sorensen: Art Vandelay.

Mark Kohler: I always wondering why are you an engineer? I always wanted to be an engineer. OK, so OK. So that so everybody, if you’re with that, just that’s an important concept because when people hear UBIT they think of it like a prohibited transaction, like I can’t do this with my retirement account because of UBIT, no you can you just have to deal with UBIT. So Mat is going to explain the best way to deal with UBIT.

Mat Sorensen: But I like OK, like Mark said, it’s a 37% rate when you hit it. So you want to avoid it at all costs. Now, the best way to avoid it is what’s called a blocker corporation. So let me give you an example out of client. A large Roth IRA does a lot of real estate and he ran into this deal that needed development. It’s like I can’t just buy the land and set it and sell it. It’s like I got to develop the whole thing out of my way too much money on the table, like, all right, you can do this real estate development. It’s going to be a hundred plus parcels and it’s a little mix of retail and commercial. But some single-family homes is big, is a bigger deal. Millions of dollars here. And it’s like, OK, well, going to pay 36% UBIT. He’s like, I don’t want to do that. That’s insane. So we did a blocker corporation instead. Now what we did is just an LLC. We added a C Corp election to it. Now that Blocker Corp, as we call it, receives that income pays corporate tax just like when you’re Apple pays corporate tax or maybe they don’t because they’re in Ireland, you know what I mean? But like, you know, the corporation with a C Corp pay corporate tax at 21% and there might be a corporate tax in the state depending on the state we’re talking about in the. Then the income from the corporation or the Blocker here goes down to the IRA as a dividend, no tax IRAs don’t pay tax on dividend income exempt from UBIT, so you’re able to do there with the Blocker Corp. And what this client did is he’s like, you know, I can pay 21% tax to do a real estate development. This was in Texas where they have no corporate tax with my Roth IRA and all that profit’s going to go back into the Roth IRA with no tax after the 21%. Exactly. Well, that’s better than any rate I get personally. That’s definitely better than 37% UBIT. And that worked. OK, that was a good instance of I’m still going to do this. I know there’s UBIT there, but let me think of a solution to minimize it. The Blocker Corp. and it was still better than what he’d pay personally in doing the deal.

Mark Kohler: Ok. I love it. Now let’s add a couple little nuances. You may think, what about state tax, so let’s say this guy that Mat said was doing the development, it was in Arizona, Texas, Texas. Oh, is Texas OK? That very good. Texas. Yeah. Let me I just want to confirm. Ok. They have a franchise tax in Texas, which I think was going to apply in that situation. And so you chose Texas all because it’s a franchise tax. It’s a little different. Let me just say this in general around the country, actually, when I was right out of law school, I Clerked or was a young accounting associate at KPMG, one of the big five accounting firms at the time in the state tax department, which was huge because in a situation like Mat example, you pay the 21% federal rate, but do you pay state? So if you’re doing a project, the restaurant, the development, let’s say it was Arizona with this Blocker Corporation, you pay the 21% fed and whatever the applicable state corporate tax rate is. And then you issue the dividends, you have to keep that in mind. The other thing I would say is too some you may say, well, I’m just doing mining or I’m doing online sales in my blocker corporation. So I’m going to set up my blocker in Nevada or a state that has no corporate tax or franchise tax whatsoever. So I get out of the state tax portion, which can add up quickly. The problem is you have to look at a word that’s called Nexus. And so Nexus means really physically, where is the work being completed? So if you’re doing servers or computers or people that are typically going to be managing this operation, which can’t be you where’s their butt sitting? So if you have a little mining server sitting in Arizona, but you set up your entity in Nevada, Arizona is still going to say, whoa, whoa, whoa, tiger, we got ya. You need to pay corporate tax in Arizona because your operation is sitting on a server in Arizona. So it’s a little more of a nuance that you’ve got to plan around with some strategy. We love to talk about it, but UBIT with a blocker. Is federal and state tax a little tidbit?

Mat Sorensen: Yeah. Now there are some states that have a state UBIT tax also, you know, California, Massachusetts, I believe Illinois too. So that’s another little little little doozy, OK. Now, remember, if you do have you that you file a 990-T for the IRA and the IRA pays the tax. All right. This is not on your personal 1040. Should I accept the challenge on UDFI. You ready?

Mark Kohler: Or let’s think. Now, we are going to do a show here soon on cryptocurrency and mining. Because mining is subject to UBIT and you don’t want the appreciation to take place in your mining entity. Because you would pay corporate tax on that, because any income you earn in that Blocker is subject to it. So in a mining operation, which we’ll explain further and this is a good time to give a plug here on April to everybody, if you’re listening to this podcast, this is a no brainer. You’ve got to get to our website and sign up for the sixth semi-annual Self-directed IRA Summit. This is on April 23-24. It will be virtually broadcast the fall event. We’re going to get back to being a person. So that is what it is in October. But this semi-annual conference, we’re going to dedicate a good hour or two on all of these types of issues, each one independently, like mining, UBIT, things like that. So just keep in mind that with mining, since you earn the cryptocurrency, you want to get it out of your Blocker so the appreciation can be a separate entity that’s not subject to the Blocker tax. So lots of tricks here. UDFI. I’m good. Yeah, the challenge is now being taken. Ok, all right. You’re now entering the gauntlet.

Mat Sorensen: I feel like I’d rather take the ice bucket challenge or something, you know. All right. Are going to explain UDFI or do the ice bucket challenge all right UDFI. This is unrelated debt financed income. OK, what the heck does that mean? You know what the definition of this is so complicated. It’s basically when you make money on leveraged debt in a retirement account. So if you have money in a retirement account and you leverage the purchasing power because you don’t have enough money to make an investment, so you’ll get debt so you can buy a bigger investment. The IRS wants the tax from the profits on the debt. The best way to understand this is an example, OK, let’s say you’re buying $100,000 property with your IRA and you only have 40 grand in it to make a down payment. So you’ll get a loan for the other sixty thousand dollars. And you can do that. Your IRA can get debt. Has to be non-recourse what’s called the nonrecourse loan. We have lenders that do that know how to do it in compliance with IRA rules. You’re not guaranteeing or signing on the loan personally. OK, so your IRA goes and buys property for hundred, puts down 40, gets a loan for 60. Now the IRS looks at that and they’re like, you know what, 60 percent of this deal is not retirement plan money. It’s non retirement plan money. It’s just debt. Those retirement plan contributions or growth on a retirement account. This is just debt. So the IRS wants to tax the profits from the debt. So in this example, if you made ten thousand dollars, let’s say in rent, after all your expenses, you could expense everything, depreciation, all that, they’re going to say, OK, you have ten thousand hours of net income. We’ll let four thousand of that. The percent that represents the IRAs, cash go back to the IRA. No tax, but the other 60 percent. That wasn’t retirement plan funds. That was debt. The money gets to go back to the retirement account, but you’ve got to pay a toll. And that’s this UDFI tax, which on rents is 37%. And there’s a stage, you get up to thirty seven percent, but that’s the max and you hit that at about twelve thousand of income. But let’s just say for now you’re going to pay 37% on that. Six thousand. OK, you’re not at six thousand but just hang with me here. It’s a little less so you know you might be paying a couple of thousand bucks in tax to the IRS. Now when you sell an asset, you apply the same thing. How much debt was on the asset at the time of sell and versus what the acquisition of that asset was? Let’s say you bought the property again for one hundred forty thousand was from the IRA. Sixty thousand was the debt. Let’s say you sold it and there are still sixty thousand in debt at the time when you sold it for a ten thousand dollar gain. Again, ten thousand dollar gain, 60 percent subject to UDFI. Now at the time of sell though, you pay capital gains tax rates, you get that capital gains rate, which is 20% essentially here. So you’re going to pay 20% on a gain of six thousand, which means you got to pay twelve hundred bucks right now. Again, that’s a ten thousand dollar gain. You were able to buy twice as much properties you could have you could only have bought a forty thousand on a property with cash, which, you know, maybe that’s a mobile home or some some meth lab rental in the Midwest. I don’t know. But but now you’re able to use debt, get a bigger purchase price, you know, to to execute the deal. So it’s not the end of the world. UDFI is actually a lot of clients benefit from it. They are able to buy more assets by getting non-recourse loans, particularly real estate clients. But you do need to know about that when you’re going out to get a loan, that when it is leveraged or even a partnership, you’re invested in a fund that’s got debt. That debt could trickle down because UDFI for your IRA. Now, one cool caveat, solok’s are exempt.

Mark Kohler: Well, then all you want to do is just want to you want to just do a monologue here is OK.

Mat Sorensen: I mean, I thought it was my challenge.

Mark Kohler: No, no, hold it. I gave the UMAY and then you gave blocker. OK. OK, so now this is important. And all kidding aside, think about this. The UBIT is 37%. We use the blocker to bring it down to 21%. UDFI 37%. But we could get more.

Mat Sorensen: Or capital gains rate if on the sell an asset or you get capital gains rate on the sale of an asset.

Mark Kohler: So you could get capital gain rates of thirty-seven, but we can only take it down to twenty-one. We can get rid of it with kind of a blocker type strategy, which is so if you think of the Blocker is to minimize UBIT. The 401k is used to limit UDFI, so what’s cool here is that whenever we do a consult with a client to go, yeah, I might have some nonrecourse debt, I might use debt in any form to expand this business, grow it, buy real estate, whatever it is. And we say, hold it, aren’t you doing this in an IRA? Go. Yes, we say stop. Let’s set up a 401k, a Solok maybe under one of your other small businesses, roll the IRA into the 401k and do the same deal. And all we have is the cost of the setup of the 401k. OK, but now UDFI does not apply. A 401K is exempt from UDFI period. So think of that like a blocker and sort of thing.

Mat Sorensen: Yep. Yeah. And it’s only exempt on leveraged real estate. So keep that in mind. A lot of people like, oh, I’m using a solo solo 401k because I don’t have to pay UBIT so I flip houses wrong. UBIT still applies to soloks. It’s just the UDIA on leveraged real estate where there’s an exemption where the soloks get out. But that’s pretty cool if you’re buying properties with debt clients that buy stuff subject to essentially seller financing involved there. If you’re dealing with Solok, no, UDFI even got to worry about. All right.

Mark Kohler: So, yeah, may I say something before we change topics? I want to get back to this because I felt incompetent as the resident CPA on the show to not have the Texas corporate tax rule at the tip of my tongue, which is, you can imagine, not easy, even in my handy dandy Mark Kohler calendar, which I’m holding up for those sort of watching on YouTube. I have all these little tables and maps and charts talking about taxes and all the different states. But here’s the deal with Texas. The franchise tax on a C Corp in Texas is assessed on the gross revenue. And the no tax due threshold this year in 2020 is one million one hundred thousand and eighty dollars one million, one hundred and eighty thousand dollars. So if you have a C corp in Texas, you don’t pay any corporate tax, which is assessed as a franchise tax, as a as a small percentage of the gross receipts, it doesn’t kick in until 1.18 million. So if you’re a little your little Blocker corp doesn’t have a ton of revenue, you’re not even going to pay the Texas tax. Sorry, I just have to let people know we’re going to get the answer right now.

Mat Sorensen: That’s I mean, I appreciate your commitment to the listeners and coming back and not leaving that unanswered.

Mark Kohler: Thank you. I appreciate that. Ok, but this is how short the show is. This is a person too much more. What would you say?

Mat Sorensen: Yeah, I mean, that’s that’s what you need to know. Now, I’ve got a whole chapter in my book, The Self-directed IRA Handbook on it. We go over it at length and go over some other strategies at the summit on it. But for purposes of the podcast and we know, you know, you can only talk so much about UBIT and UDFI on a podcast or YouTube video before you start getting thumbs down. Oh, I think we.

Mark Kohler: I’ve got one guy I was clicking my fingers, so sorry for that, kind of skipped over Mats voice there. I’ve didn’t mean to ping the microphone with that. OK, here’s a point, too. And you tell me I always learn something new with Mat. I said this at a training meeting today for employees I go. I always learn something new from Mat, even on our podcast, because we really dive deep on a lot of these topics. And I’m sharing things that Mat doesn’t know sometimes, such as Brad Pitt and Jennifer Aniston’s love affair. I think it’s very important that.

Mat Sorensen: If you guys here make sure you listen to the Main Street business podcast with Mark gave an update on, you know, Brad Pitt and Jennifer Aniston.

Mark Kohler: Yeah. Yeah, very important. Ok, here’s another interesting point with UDFI, let’s say in Mat example, you bought this property, you had debt and you’re getting ready to sell it and you’re like, darn it, I don’t want to pay this tax. Could I move the ownership of that LLC IRA. As a contribution and or a transfer to a solo 401k before I sell?

Mat Sorensen: Absolutely. So there’s a lot of strategies you got with UDFI, one would be if you qualify, you have to own a business to establish. So, OK, but if you qualify, it stops the Solok do an income transfer of the LLC ownership that owns the property from your IRA to your solo k. OK, now you’ll need to hold the property for 12 months in the solok, ok, ok. Then you sell it and you’d have no debt. Another strategy. I’ve had four clients and I’ve done this on a number of times. Let’s say you have a property. And see, here’s the thing with the UDFI, a lot of clients because they have all the expenses, you taking depreciation, you’re taking mortgage interest. You’re not worried about UDFI year to year if you have it. It’s very little, but a lot of times you have a loss on the property from a tax standpoint. So there’s no you find the rental income, but over time you pay down the loan the property appreciates. Now you’ve got a UDFI problem when you sell. Good way around that is I’ve had clients bring in a JV partner that takes some equity, maybe they take five percent of the equity in the property. When you’re going to sell that JV partner, throws in some cash, pays off the debt, and now you hold the property for 12 months with no debt. See, when they look at how much debt you have to apply, UDFI, they look at the time of sell the IRS and then the prior 12 months to average it out. So if you had zero debt over the last 12 months, when you look at the leverage percent, it’s going to be zero. So if you can bring in partners or equity people in a JV agreement’s easiest, maybe some will bring them into your LLC. That’s a great way to avoid UDFI tax on the sale of the property. So lots of strategies there to try and get rid of it. Also, I just see clients just wind down paying debt on the property so they’ll just apply all the cash that they can to pay off the debt or they’ll roll over other IRA money if they have it, or make new contributions to pay off the debt. Then again, hold the property 12 months with no debt. Then when you sell, there’s no UDFI at the time to sell. So there you go. That’s unrelated business income tax. UBIT. Sometimes called you UDFI, an unrelated debt financed income tax. Again, there’s some more resources in my book where I’ve got a chapter on it. There’s also resources on the Directed IRA website and at KKOSlawyers.com. And thanks again for being here on the Directed IRA podcast. We’re going to be back next week, I believe, with Open Forum. So if you have any questions on self-directed IRAs, make sure you submit those at DirectedIRA.com/podcast or show questions. They’re DirectedIRA.com/podcast. And we will see you next week on.


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