The UBIT Tax: Be Aware but Don’t be Afraid
By Peter Rizzo
Every week, a number of prospective clients and current clients contact us about the fear of UBIT taxes. We are finding that many self-directed real estate IRAs don’t address this topic and people that are unaware can be subject to some hefty taxes when properties are liquidated.
Don’t let the tax scare you away from these investments for there can be very good returns received even after paying the tax; just be sure to understand them. Many articles have been written on this subject and here is a compilation of some of the main points:
The Internal Revenue Service (“IRS”), as stated on its website, has always permitted an IRA or other retirement account to purchase, hold, or flip real estate. Using a Self-Directed IRA or 401(k) plan enables one to buy real estate, such as raw land, residential or commercial property, flip homes, and much more without paying tax. All gains from flipping homes with a retirement account are tax-deferred until a distribution is taken, which is a huge advantage. And in the case of a Roth IRA, all gains are tax-free.
UBIT is a tax that was instituted in order to level the playing field when a tax-exempt organization engages in a business activity. Imagine a University purchasing a Subway franchise. Because the University is tax-exempt, it wouldn’t be very fair to the fellow who owns the Subway across town, to pay taxes on everything he makes, while the University pays no tax. The UBIT rules treat these tax-exempt entities, which include IRAs and 401(k) plans, as for-profit businesses when they invest in an active trade or business operated through a pass-through entity, such as an LLC or partnership (a C Corp would be treated differently) or use leverage (there is an exemption to the UBIT rules for 401(k) plans who use nonrecourse leverage). The tax imposed by triggering the UBTI rules is quite steep and can go as high as 40 percent. You must remember though if you are leveraging your investment you are making money on someone else’s so adjust your rate of return accordingly.
Congress passed legislation in 1950 out of concern that tax-exempt organizations would have an unfair advantage over for-profit companies that had to pay tax.
Most passive investments that a retirement account might invest in are exempt from the UBIT rules. Some examples of exempt types of income include: interest from loans, dividends, annuities, royalties, most rentals from real estate, and gains/losses from the sale of real estate.
However, for real estate investors looking to buy and sell multiple real estate properties in a year or use leverage, one must be conscious of the application of the UBIT tax rules.
Generally, a few real estate transactions in a year would not rise to the level of a trade or business and trigger the UBIT tax rules. The question then becomes what happens if your retirement account engages in five, six or even ten flipping transactions in a year – would that be considered an active trade or business and, hence, trigger the UBIT. The burden falls on the retirement account holder to make the determination of whether the retirement account engaged in a trade or business. Therefore, it is important to work with a tax professional who can help one evaluate the transaction to determine whether the flipping transactions will trigger the UBIT tax.
Consequently, if you understand the rules of flipping properties and leveraging your investments these two investments can be a great source for maximizing your rate of return.