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Many people wrongly assume that income to an IRA is always exempt from tax. This is definitely not true. Earnings within an IRA (or IRA/LLC) are generally exempt from tax. However, certain investments create taxable income called “unrelated business taxable income” (UBTI). UBTI is income from a trade or business regularly carried on by the IRA. The tax code defines any active trade or business to be unrelated to the IRA’s purpose. However, there are certain types of income that are excluded from UBTI such as rental income, interest from loans, dividends from corporate stock, royalties, etc.

The basic idea behind the UBTI rules is that Congress did not intend for IRAs to compete with active businesses. Rather, an IRA is designed to be a passive investor. In an ideal world, the tax on UBTI puts IRAs on an equal playing field with other active businesses. However, because an IRA is taxed on UBTI at trust rates (which are high), an IRA can actually owe more tax than a similarly situated individual who is operating the exact same business.

There are certain types of investments that, while acceptable for a self-directed IRA to make, are subject to being taxed at what are commonly referred to as “trust rates” (see table below). You’ll want to be conscious of any transactions that might trigger unrelated business taxable income (UBTI). This is one area where it may take more than common sense to navigate the tax code. If you suspect you may be about to make a transaction that could generate UBTI, it is advisable to work with a tax professional.

The government requires that all businesses in the U.S. pay taxes. If any business sells some or all of its products or services without paying taxes, it would have an unfair advantage over its competitors. For this reason, UBTI could be triggered if your IRA owns all or part of a business that earns its income through the sale of a product or service. Flipping real estate and developing land for resale are examples of investments that are, more often than not, considered “businesses”—which makes profits generated by such activities fair game for taxation. However, there is much discussion on how many properties you can buy and sell in a year without having this issue, but the real question is your intentions when you bought the property. Again, it is not clear cut and therefore you should get you CPA involved in your decisions.

FYI – Rental income is not subject to UBTI; however, if your investment was made using your IRA money plus debt financing or leverage, portions of the income/profits you make would be subject to UDFI (Unrelated Debt Financed Income). We will discuss UDFI in more detail in a later article. This tax would apply only to the percentage of profit realized through borrowed capital, not through your own retirement funds.

UBTI Examples

1. IRA purchases a ice cream shop and pays an unrelated third-parties to operate the business. The income from the coffee shop will be treated as UBTI to the IRA.

3. IRA makes a loan to an unrelated business. Rather than only interest being paid back to the IRA, the business agrees to pay a percentage of its profits (like a private equity deal). The income associated with the disguised equity will likely be subject to UBTI because it does not constitute interest. If the IRA received interest only then there would be no UBTI.