The primary advantage of using an IRA account, specifically a Self-Directed IRA, to make investments, including both traditional and nontraditional, or alternative, investments is that, in general, all income and gains from the investment are exempt from federal income tax and flow back to the IRA without tax. Taxes are deferred until distribution in retirement, or tax free in the case of qualified distributions from a Roth IRA.
Internal Revenue Code (IRC) Sections 408 and 512 exempt most passive forms of investment income generated by a Self-Directed IRA from federal income taxation. The most common forms of passive income exempt from taxation include interest dividends, royalties, rental real estate income, and capital gains. However, in certain instances, the Unrelated Business Taxable Income (UBTI) tax could be triggered and turn a tax-advantageous investment into a taxable investment. In the following, we will explore different methods to avoid UBTI.
- Can UBTI turn a tax-advantageous investment into a tax nightmare?
Yes, when UBTI is triggered, it can convert what would typically be a tax-deferred or tax-free investment into a taxable one, significantly reducing your investment returns. - When does the UBTI tax apply?
The UBTI tax applies in situations such as using debt financing to acquire investments, investing in an active business through an LLC or partnership, or engaging in certain real estate investments. - Can you avoid the extra tax in certain situations?
Yes, structuring your investments carefully, such as using a C Corporation or opting for loan-based investments instead of equity, can help you avoid triggering UBTI.
What is Unrelated Business Tax?
For most retirement account investors, there is no reason that they would have ever heard of the UBTI tax. While most investors are familiar with a standard IRA account, few are aware of the complexities involved in Self-Directed IRAs and the potential for UBTI. The main reason for this is that the majority of investors invest in traditional types of investments, such as equities, mutual funds, and ETFs, which do not trigger the application of the UBTI tax rules.
In general, the UBTI tax is triggered in three types of investment categories involving retirement accounts:
- Using margin to buy stocks or securities
- Using a non-recourse loan to acquire real estate (there is an exemption for 401(k) plans under certain conditions). The loan cannot be guaranteed by the IRA owner pursuant to the prohibited transaction rules.
- Investing in an active trade or business operated through an LLC or pass-through entity, such as a partnership.
IRC Section 511 taxes UBTI at the trust tax rates, which is quite high. For 2025, the highest trust tax rate is a whopping 37%!
What are the Filing Requirements for Unrelated Business Taxable Income?
In computing UBTI, a specific deduction of $1,000 is permitted. If an IRA has a gross UBTI of $1,000 or more during its fiscal year, it must file a completed IRS Form 990-T to report such income and pay any taxes due. Form 990-T is due at the same time as Form 990. Failure to file can result in significant penalties and an increased tax bill for the IRA.
What Triggers UBTI in a Self-Directed IRA?
Unrelated Business Income Tax (UBIT) is triggered in a Self-Directed IRA when the account generates income from an active business or investment that is not exempt from taxation. This typically occurs when a Self-Directed IRA invests in a business or investment that is not considered passive, such as a rental property. Additionally, if an IRA uses debt financing to acquire an investment, the income generated from that investment may be subject to the tax, but there are ways to avoid UBTI!
Examples of investments that may trigger UBTI include:
- Investing in a partnership or LLC that operates a business
- Investing in a real estate investment trust (REIT) that generates rental income
- Investing in a private equity fund that generates income from operating businesses
- Using debt financing to acquire an investment property
It’s essential to note that not all investments in a Self-Directed IRA will trigger UBTI. For instance, investments in stocks, bonds, and mutual funds are generally exempt. Understanding what triggers the tax can help you make informed decisions about your investments and avoid unexpected tax liabilities.
Excluded Investment Income
Excluded investment income refers to income types not subject to UBTI. In a Self-Directed IRA, the following types of income are generally excluded:
- Dividends
- Interest
- Capital gains
- Rents and royalties
However, if borrowed funds are used by the IRA or the investment vehicle to generate any of these types of income, it may be subject to UBTI. For example, if a Self-Directed IRA uses debt financing to acquire a rental property, the rental income generated from that property may be subject to the tax.
It’s crucial to consult with a tax professional to determine which types of income are excluded in an IRA. This can help you structure your investments in a way that minimizes your tax liability and maximizes your returns.
Calculating Unrelated Business Taxable Income
UBTI is calculated by subtracting deductions from Unrelated Business Income (UBI). UBI includes income from investments that are not exempt from taxation, such as income from operating businesses or debt-financed investments.
To calculate UBTI, follow these steps:
- Determine the UBI generated by the Self-Directed IRA.
- Calculate the deductions allowed for the UBI, such as operating expenses or interest expenses.
- Subtract the deductions from the UBI to determine the UBTI.
For example, if a Self-Directed IRA generates $10,000 in UBI from a partnership investment and has $2,000 in deductions, the UBTI would be $8,000. Understanding how to calculate UBTI is essential for managing your tax obligations and ensuring compliance with IRS regulations.
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How to Avoid UBTI
Investment Income vs. Business
In general, the determination of whether a transaction or series of transactions involving a Self-Directed IRA will trigger the UBTI tax is based on the facts and circumstances on whether the activity rises to a trade or business versus a passive investment. Self Directed IRAs require careful planning to ensure that the activities do not rise to that level, thereby triggering UBTI.
A trade or business is defined as any activity which is carried on for the production of income from the sale of goods or the performance of services. Regarding the requirement that the trade or business be “regularly carried on,” the essential inquiry is as to the frequency and continuity of the activities.
In other words, for a Self-Directed IRA investment to be deemed a business versus a passive investment, the activity must be carried out on a regular basis with the intent to produce income. In most cases, it is clear whether an activity will be deemed a business versus a passive activity.
However, in the case of real estate, the determination of whether the real estate activity is deemed a business and, thus, subject to the UBTI tax, is dependent on the following factors:
- Frequency of transactions
- Level of continuity
- Level of improvement
- Intent
- The proximity of sale to purchase
- The purpose for which the asset was acquired
- Personal activities of the taxpayer
C Corp Blocker
Using a C Corporation to block the application of the UBTI tax is a popular way used by many investment funds. A C Corporation is taxed as a separate entity from its shareholders and is subject to a corporate entity tax. Whereas a pass-through entity, such as an LLC, is deemed a flow-through entity because there is no entity level tax. All LLC income and gains flow through to the members where the members pay tax on the income. While IRAs are generally tax exempt, using a C Corporation can help manage specific tax liabilities like UBTI.
Therefore, if a Self-Directed IRA uses a C Corporation to invest in a business or fund, the income and gains would be subject to corporate income tax, which is currently taxed at 21% on the net corporate income but would not be subject to the UBTI tax. This is because a C Corporation blocks the flow-through of the UBTI tax. This is why most investors have never heard of the UBTI tax since most IRAs are invested in publicly traded company stocks, which are almost exclusively set up as C corporations and not LLCs.
A C Corporation blocker solution will not erase tax due from the income or gains from an investment, but it will limit the tax to 21% versus the maximum UBTI tax rate of 37%.
For example, if a retirement account investor is seeking to invest retirement funds into an active business operated through an LLC, such as a retail store, he or she can establish a C Corporation, invest the IRA funds through the C Corporation, and then have the C Corporation invest the funds into the retail store LLC. All income received by the C Corporation would be subject to the now-reduced corporate tax rate of 21%.
Read More: UBTI Tax & The Corporation Blocker
Debt Vs. Equity
If a Self-Directed IRA can structure an investment into a flow-through business or fund as a loan versus equity, it would not be subject to the UBTI tax. This is because interest on a loan is exempt. However, the debt must be real debt and not be equity disguised as debt. For example, the loan must have a stated rate of return and the return cannot be based on the profits of the business or on a certain investment goal. Properly structuring investments within your IRA account can help avoid the pitfalls of UBTI.
The downside of structuring an IRA investment as a loan versus an equity investment is that the loan returns are typically capped at the interest on the loans, whereas, equity investments typically do not have a cap since the equity can be worth as much as the company or fund sells for in the future.
Prohibited Transactions and Investment Income
Prohibited transactions refer to investments or activities that are not allowed in a Self-Directed IRA. Engaging in these transactions can result in penalties and excise taxes, and may even disqualify the IRA.
Examples of prohibited transactions include:
- Investing in collectibles, such as artwork or coins
- Investing in life insurance contracts
- Investing in real estate that is used for personal benefit
- Borrowing from the IRA or using IRA assets as collateral for a loan
Investment income generated from prohibited transactions may be subject to UBIT and may also result in penalties and excise taxes. It’s essential to be aware of these restrictions to avoid costly mistakes and ensure that your Self-Directed IRA remains in good standing.
IRA Investment and Transaction Rules
IRAs are subject to specific investment and transaction rules that must be followed to avoid penalties and excise taxes. These rules include:
- Prohibited transactions, such as investing in collectibles or borrowing from the IRA
- UBIT rules, which require the IRA to pay tax on income from certain investments
- Investment income rules, which require the IRA to report and pay tax on certain types of income
- Transaction rules, which require the IRA to follow specific procedures for buying and selling investments
It’s essential to consult with a financial planner or tax professional to ensure that a Self-Directed IRA is in compliance with all applicable rules and regulations. This can help you avoid penalties, optimize your investment strategy, and ensure the long-term success of your retirement planning.
Manage Your Real Estate Investment
The UBTI tax is only triggered if the net income or gains allocated to the Self-Directed IRA is above $1,000 for the taxable year. Thus, if you can keep that number below that amount, no UBTI tax would be due. For most business and investment fund investments, this may not be possible since the IRA will likely not have control over the operations of the business or the fund.
However, in a direct real estate investment by a Self-Directed IRA, where the IRA owner has more control over expenses, such as debt payment servicing, managing the cash flow of the real estate investment is a possibility. For example, if a Self-Directed IRA bought a home and used IRA funds and a non-recourse loan, the IRA owner could try increasing loan payments, accelerating depreciation, or making improvements to reduce the net cash flow below the $1,000 amount. Strategically managing your IRA contributions can also play a role in minimizing UBTI from real estate investments.
Learn More: Real Estate Investing with a Self-Directed IRA
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In conclusion, understanding and avoiding UBTI is essential for anyone using a Self-Directed IRA to invest beyond traditional assets. While alternative investments like real estate, private equity, and limited partnerships offer the potential for significant growth, they can also expose your IRA to unexpected tax liabilities if not carefully structured.
By staying informed, working with knowledgeable custodians, and consulting tax professionals, you can navigate the complexities of UBTI and ensure your IRA remains a powerful, tax-advantaged tool for building long-term wealth.
