Steven Merrell, Financial Planning: Surprise! When your IRA owes taxes

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Tax season can sometimes bring unpleasant surprises. One such surprise came to an individual who called me with concerns about his self-directed IRA. Several years ago, he invested his IRA in an LLC that buys and renovates aging mobile home parks. The portfolio of properties has expanded considerably over the years and now produces a significant amount of monthly cash flow—enough to pay the mortgages on the properties and still provide a nice income stream to investors.

Sounds good, doesn’t it? Except there’s a problem. Nobody told this investor that his investment was producing something called Unrelated Business Taxable Income, or UBTI. Because his IRA was invested in an LLC, the IRA actually owes tax on the income and profits from his investment—taxes that have gone unpaid for more than a decade. Here’s how it works.

Tax-exempt organizations like charities and churches—and IRAs—may own interests in businesses with operations that are not central their tax-exempt purpose. However, if these “unrelated” business interests produce income greater than $1,000 per year, the tax-exempt entity must report the unrelated business income and pay tax on it. This is where a lot of people get confused with UBTI in IRAs. They reason that the tax-exempt purpose of their IRA is to provide for their retirement so any income produced by their investment is central to that purpose. Unfortunately, the IRS disagrees.

There are two general ways in which an IRA can create UBTI. The first is by investing in an operational business organized as a pass-through entity like an LLC or limited partnership. Pass-through entities do not pay taxes on their profits, rather they pass the profits through to their members or partners. If the member or partner were an IRA, those profits would never be taxed and the business would have an unfair advantage over its taxable competitors. Note that IRAs can invest in C-Corporations without fear of generating UBTI since the C-Corporation is a tax-paying entity.

The second way for an IRA to generate UBTI is for the IRA to borrow money to make an investment. To the extent that an IRA’s income-producing assets are purchased with non-recourse financing like a mortgage, they may generate something called “unrelated debt-financed income,” or UDFI. UDFI is a subset of UBTI. UDFI is considered unrelated to the IRA because it is generated with borrowed money, not IRA assets.

For example, let’s suppose your IRA purchases a rental property for $300,000 using $150,000 of IRA money and $150,000 from a mortgage loan. Because half of the investment was purchased with borrowed money, half the income is considered unrelated debt-financed income. The IRA will owe unrelated business income tax on the UDFI.

UTBI and UDFI should not automatically disqualify an investment from consideration, but the tax impact needs to be carefully considered before making the investment. IRAs are taxed as trusts which means their marginal tax rates ramp up much more quickly than the tax rates for individuals. For 2023, the highest marginal tax rate for trusts is 37% and it is applied to trust income of $14,451 and higher. Individuals, by comparison, can earn up to $578,125 before hitting the 37% tax bracket.

Remember also that the IRA is considered a legally separate entity from the IRA holder which means it is the IRA that owes the tax on UBTI, not the IRA holder, though the IRA holder is ultimately responsible. The IRA holder is prohibited from reimbursing the IRA for taxes paid and receives no credit for taxes paid by the IRA.

If you want to use your IRA to invest in opportunities that might produce UBTI, there is a fairly easy way to avoid UBTI issues. Simply create a C-Corporation as an intermediary step. The IRA can invest in the C-Corp without fear of UBTI and the C-Corp can invest in whatever investment you want to make. Of course, the C-Corp will be taxed, but it will be at the maximum corporate tax rate of 21%.

UBTI issues are complicated. If you worry that an investment in your IRA might be producing UBTI, you should talk to a financial advisor with experience in this area. You should also discuss any possible tax exposure with your tax professional.

Steven C. Merrell is a partner at Monterey Private Wealth Inc., an independent wealth management firm in Monterey. He welcomes questions you may have concerning investments, taxes, retirement, or estate planning. Send your questions to Steve Merrell, 2340 Garden Road Suite 202, Monterey, CA  93940 or email them to smerrell@montereypw.com.