Many IRA owners believe that all investment and other income earned in their IRA will not generate any current income tax bill. This is not correct. There are certain transactions that can generate what is called “Unrelated Business Taxable Income” (UBTI). Unfortunately, these rules apply to all types of IRAs, including Traditional, Roth and SEP accounts.
In general, UBTI is designed to prevent charities, trusts, IRAs and other non-profit entities from having a competitive advantage over taxable businesses. UBTI may occur in your IRA if you can answer “yes” to both questions:
- Is the income earned in your IRA from a trade or business that is regularly carried on?
- Is the trade or business unrelated to your tax-exempt purpose?
In addition, UBTI can also be triggered if your IRA earns income via debt-financed transactions. This is very common when rental real estate is purchased through an IRA. For instance, if your IRA purchases a rental property and uses a 20% down payment, income from the 80% debt financing may trigger UBTI. Although rental income is considered to be exempt from UBTI, 80% of the rental income (based upon the amount financed) would potentially be subject to taxation. This is not normally a problem because only the net rental income would be subject to tax and with expenses, including mortgage interest and depreciation; there will not typically be any UBTI and thus no taxes to be paid.
There are several possible ways that UBTI may be generated in your IRA:
- Running an active trade or business (such as a law practice, gas station, etc.)
- Receiving income from operations involving a pass-through business entity (LLC, LP, S Corporation, etc.)
- Using margin on stock transactions
- “Fix and Flip” real estate (considered a business and not an investment activity)
- Using a non-recourse loan to purchase the property (it is also a “prohibited transaction” to use a recourse note in your IRA)
Like every other tax law, there are exceptions to this type of taxation. Here are a few that are not subject to UBTI:
- Dividend income
- Interest income
- Royalties
- Rents from real estate
- Research for a federal, state, or local government
- Charitable contributions, gifts, and grants (for a non-profit organization)
- Sales proceeds from the sale of real property (for rental properties- not flipping properties)
If your IRA has UBTI and the gross income exceeds $1,000, it will be required to file a tax return (Form 990-T) and this is due on the same date as personal tax returns (April 15). Please be aware that the tax rates are much higher than the individual tax rates due to the fact that the rates for trusts apply to UBTI and Form 990-T. It only taxes $12,400 of taxable income (i.e. after deductions) in 2016 for the top 39.6% tax rate to be achieved. Tax planning is critical in this area because paying tax on UBTI can also generate a double-tax bill, as the same funds taxed for UBTI purposes may be taxed again upon distribution to you (or your beneficiaries).
For more information on UBTI, please see IRS Publication 598, available at www.irs.gov.