The most common asset class for Self-Directed IRA accounts is real estate. Real estate investments for Self-Directed IRAs come in various forms from simple single-family rentals owned 100% by the IRA to LLC or LP investment partnerships with multiple investors in larger commercial or multi-family properties.
When investing your self-directed IRA into a real estate syndication, private placement memorandum or offering (PPM), or other partnership, you must learn and understand one very important tax called UBIT tax (unrelated business income tax, aka, UBTI) that may apply to your self-directed IRA’s income.
Will My IRA Be Subject to UBIT Tax?
Unrelated Business Income Tax (“UBIT”) applies to an IRA that receives non-passive income. UBIT is a hefty tax and has a maximum rate of 37%. IRC § 511. The tax table is copied below.
2024 Tax Rates for UBIT are the trust tax rates.
Although not shown in the table, the first $1,000 in UBIT gross income is exempt, and you will receive an automatic $1,000 deduction.
UBIT will apply to your self-directed IRA real estate investment in two scenarios. First, it will apply if the income to the IRA is ordinary. And second, it will apply if the offering company uses debt to acquire its properties.
Step One: Is the income passive?
First, UBIT will apply if the investment is an ordinary income-producing business. An ordinary income business in real estate investing would include investing in an LLC or LP that conducts new construction, real estate developments held for sale, or other activities that are deemed business activities. On the other hand, passive income investments are specifically exempt from UBIT and include real estate rental income, capital gain income, interest income, and dividend income from a C-corp. IRC § 512(b). Most real estate private funds are structured to obtain passive income, such as rental income while the property is held and capital gain income when the property is sold. Typical real estate offerings where UBIT can be due include offerings to fix and flip properties or offerings for new construction or real estate development. The investment strategy is to buy properties to sell immediately.
If you have an investment offering that is ordinary income (e.g., a fix and flip fund), then the income to the IRA from the fund will be subject to UBIT tax, and the IRA will be required to file and pay the tax each year by using IRS Form 990-T. This responsibility to file the return each year is on the IRA account owner and not the investment sponsor or the IRA custodian, so IRA owners need to know for themselves whether the IRA is subject to UBIT or not. So, for example, let’s say that a self-directed IRA invested into a private real estate fund that was a real estate development with properties held immediately for sale and that the income was ordinary income. Let’s further assume that the self-directed IRA received a K-1 for profits (net after all expenses) to the IRA for the year of $10,000. Based on the UBIT tax table, the IRA would owe UBIT tax in the amount of $1,996. This amount is due from the IRA to the IRS and is reported and payable using form 990-T.
If you’ve determined that the Crowdfunding offering income is passive (e.g., rental, capital gain), then you may still be subject to UBIT if the LLC or LP offering company is using debt to leverage and acquire its properties.
Step Two: Will the investment be leveraged with debt?
Second, UBIT will apply to profits returned to your IRA from a real estate fund (and any real estate owned by your IRA) if the company uses debt to leverage its acquisition of properties. For example, let’s say the offering company raises $1M in cash to buy a $4M multi-family property. There will be $1M of cash invested into the property and $3M of debt. The property will, therefore, be leveraged 75% with debt.
Whenever an IRA’s investment is leveraged with debt, the tax code requires the IRA owner to determine what profits are attributable to the IRA’s cash and what profits are attributable to the debt. The profits attributable to the cash invested are still treated as tax-deferred (traditional IRA) or tax-free (Roth IRA) and are not subject to UBIT. The profits and income attributable to the debt, however, are called unrelated debt-financed income (“UDFI”) and are subject to UBIT. IRC § 514. So, in the multi-family property example above, where the property is leveraged 75% with debt, the self-directed IRA will be subject to UBIT tax on 75% of the income.
To calculate UBIT tax based on debt, you must first determine the leverage ratio. Once we know the leverage ratio, we can begin calculating how UBIT will apply. The good news is that the IRA can also take expenses against the property using the same leverage ratio and can take depreciation expenses, which helps offset UBIT. In many situations, even where a property is cash-flowing, the IRA will not be subject to UBIT because the property expenses and depreciation will offset UBIT income, and the K-1, which the IRA receives, has a tax loss.
Let’s continue through this example to illustrate how this works.
Example
Property Purchase Price = $4M
Debt/Leverage = $3M
Leverage Ration = 75%
Income = $1.3M
Income at Leverage Ratio (75%) = $975,000
Operating Expenses= $1,000,000
Operating Expenses at Leverage Ratio (75%) = $750,000
Net Leveraged Income = $225,000
Depreciation Expense ($4M / 27.5) = $145,500
Depreciation Expense at Leverage Ratio = $109,125
Net UDFI/UBIT Income = $115,875
SDIRA Investor Invested $20K and received 1.5% of Company Profit/Loss
SDIRA Investor 1.5% of Net UDFI/UBIT = $1,738.
Automatic IRS $1,000 deduction = $738 subject to UBIT/UDFI
UBIT Table Rate of 10% of $738 = $74 in UBIT is Due
As the example demonstrates, given the low level of investment from the IRA, it isn’t subject to much UBIT as the net UBIT income (after expenses and depreciation) keeps the tax rate on the low end of the tax table. That being said, 990-T tax returns must be filed by the IRA investor for the IRA, and the IRA will be responsible for the tax dues. Factors that will cause more UBIT are higher returns and income, larger investment amounts and ownership, and more leverage.
This also means more net gains and growth for the IRA as it benefits from investing in larger assets that can create more return. It is more likely, though, that there will be tax losses passing down on the K-1 (because of expenses and depreciation) to the investor, which results in no UBIT/UDFI tax due, and these losses can be carried forward to offset future years where there is taxable gain.
Sale of Property, Capital Gain Example
Let’s run another example but use the sale of property as the example.
Property Purchase Price = $4M
Debt/Leverage = $3M
Equity/Cash Invested = $1M
SDIRA Put in = $150K for 10% of the Fund
Leverage Ratio = 75%
Sale Price = $7M
Expenses = $500,000
Taxable Gain = 2,500,000
SDIRA Investor 10% Share of Profit = $250,000
UDFI Taxable Income After Leverage Ratio of 75% = 187,500
Automatic Deduction of $1,000 = $186,500
Capital Gains Rate of 20% = $37,300
Net Gain to IRA After UBIT Tax = $212,700
In this example, you can see a larger tax due, and that is more common when a property is sold. However, the tax rate is only 20%, and it is only based on the leveraged portion of the deal. Since the leverage ratio is 75%, the effective tax rate (75% of 20% rate) is only 15%. If the net investment returns are better than what you could otherwise get by investing in a mutual fund or other investment, it makes sense to use an IRA, take advantage of debt-leveraged deals, and drive a greater net return and growth to your IRA.
Exemptions To UDFI For 401(k)s and for REIT Private Funds.
While self-directed IRAs are subject to UDFI and UBIT on leveraged real estate investments, it is worth noting that self-directed 401(k)s (including solo 401ks) and other employer-based plans are exempt from UDFI on leveraged real estate investments. IRC § 514(c)(9). Unfortunately, self-directed IRAs do not receive this exemption.
An additional exemption applies to many IRAs investing in private funds if the fund is taxed as a real estate investment trust. Under IRS Revenue Ruling 66-106, an IRA (or other exempt entity) is not subject to UBIT or UDFI tax on profits/dividends paid from a private fund taxed as a REIT.
Analysis of Debt-Leveraged Deals
Despite the UDFI tax on debt, we see many IRAs invest in private real estate funds for two reasons. First, most self-directed IRAs don’t see UDFI during the hold period of the property as the private real estate fund is passing down tax losses on the K-1 after considering depreciation or even accelerated expenses such as cost segregation. UDFI is more common on a real estate fund at the time of sale of the property (as the gain will exceed the expenses and depreciation) than it is during the cash-flow and hold period, and in the instance of a sale, there is UDFI due on the property, but the maximum tax rate is only the long-term capital gains rate of 20%. It’s only the debt-leveraged portion of the gain. Second, many IRAs still invest despite UBIT/UDFI as the overall net return they can get on the real estate deal (even after paying UBIT/UDFI tax) is greater than they can get in other non-leveraged real estate or stock or mutual fund opportunities.
So, in short, the quick list to determine whether UBIT/UDFI will be due on a self-directed IRA real estate investment requires an analysis of two issues. First, is the private fund’s income passive or ordinary? If it is ordinary, then it is subject to UBIT. If it is passive, then it is only subject to UBIT if the company uses debt to leverage its investments. Once you can answer these questions, you will know whether UBIT will apply to your investment and whether your IRA will need to report and pay tax on its income; while we’ve tried to illustrate how the tax is due, please consult with your tax professional or advisor as to tax and investment analysis on investments you are making with your self-directed IRA account.
