UBIT Taxes and Prohibited Transactions

Part 3 in a Series

 

The last piece of the puzzle in the self-directed retirement account world is an important one: what to avoid. We previously briefly mentioned Unrelated Business Income Tax, also known as UBIT. This is an important term to understand, yet it is so often misunderstood. In its simplest terms, UBIT applies when the self-directed IRA is the recipient of business income instead of investment income.

Investment Income vs. Business Income

 

To better understand the topic, it helps to clarify what type of income is classified as investment income, thus not subject to UBIT taxes. The five most common types of investment income according to sdirahandbook.com are[1]:

 

1. Real Estate Rental Income — The rent collected from a real estate property
2. Interest Income — The interest and points collected from lending money
3. Capital Gain Income — The sale of any asset where a profit is made
4. Dividend Income — The income received as a share of profit from a C-corp on which the company paid corporate tax
5. Royalty Income — The profit received from ownership of intellectual property or from leasing activities

 

When Does UBIT Apply?

 

UBIT comes into play when your IRA leverages debt to increase its purchasing power. The reason is that the IRS feels that while your money should be tax deferred, the benefits reaped from money borrowed should not be. So, in a transaction where you purchase a property with all cash, you would have no mortgage, so you would not be subject to the UBIT tax. However, if you use the money in your IRA as a down payment and receive a mortgage for a portion of that property, the portion that is mortgaged would be subject to the UBIT tax in a self-directed IRA. Since most real estate transactions require a 20–30% down payment, the remaining 70%–80% of the transaction may cause a significant taxable event. UBIT taxes are very real and should be given careful consideration to when evaluating your self-directed options. The best way to approach UBIT taxes is to work with a CPA who has experience working with self-directed retirement plans.

When UBIT taxes are incurred, the form used is IRS form 990-T, which must be submitted by April 15th of each year, but can be extended for 6 months, if requested.

 

Prohibited Transactions

 

Besides UBIT taxes, the second biggest drawback to self-directed plans is the potential of committing a prohibited transaction. Many times, the investor just doesn’t know any better, but the consequence of committing a prohibited transaction is severe—potentially even losing the retirement designation of your account. With a traditional retirement account, the choices are given to you. It’s a different ballgame when those restrictions are removed, and almost any option becomes available to you.

For the purposes of this article, we are going to break down prohibited transactions into two main categories: prohibited investment types and disqualified persons. This basically translates into what you can’t buy and who your IRA shouldn’t do business with.

 

Prohibited Investment Types

 

There are three main types of investments that are prohibited for a self-directed IRA:

• Collectibles
• S-corp shares
• Life Insurance*[2]

Collectibles

Collectibles fall under multiple categories, but the most common are

• Artwork
• Beverages, such as wine
• Stamps and certain coins
• Historical objects
• Rugs

While the list is more than the five categories mentioned, the main thing to note is that if you are interested in investing in anything that may be classified as a collectible, err on the side of caution when dealing with a self-directed IRA.

S-Corp Shares

A retirement plan is classified as a trust, and since trusts are excluded from being a shareholder in an S-corp, self-directed accounts are also excluded from investing as a shareholder in an S-corp. The good news is C-corps, LLCs, sole proprietorships, and partnerships are still on the table.

Life Insurance

 

This one is interesting because life insurance, in essence, is a tax-deferred vehicle (i.e., with a whole life policy, the cash value that grows in a life insurance policy is excluded while it’s growing within the policy). In later years, the option to loan yourself the cash value defers taxes on the back end of the policy. Given that most investors try to avoid putting a tax-deferred investment within a tax-deferred investment—because it dilutes the inherent benefits of each—  it’s vital to be aware up front that life insurance is a prohibited investment in a self-directed IRA.

Important note: While this is a 100% prohibited transaction in a self-directed IRA, it can be done in a solo 401(k) plan. If the reasons are strong enough to warrant such an investment (remember the tax-deferred investment within a tax-deferred investment example above)—such as not having any additional funds but needing the insurance—then according to mysolo401k.net, an individual with a solo 401(k) plan can invest up to 50% of the plan into whole life insurance and no more than 25% into term or universal[3].

Disqualified Persons

 

Per the IRS, an IRA is prohibited from transacting with the following[4]:

1. A fiduciary of the plan.
2. A person providing services to the plan.
3. An employer, any of whose employees are covered by the plan.
4. An employee organization, any of whose members are covered by the plan.
5. Any direct or indirect owner of 50% or more of any of the following.
   1. The combined voting power of all classes of stock entitled to vote, or the total value of shares of all classes of stock of a corporation that is an employer or employee organization described in (3) or (4).
   2. The capital interest or profits interest of a partnership that is an employer or employee organization described in (3) or (4).
   3. The beneficial interest of a trust or unincorporated enterprise that is an employer or an employee organization described in (3) or (4).
6. A member of the family of any individual described in (1), (2), (3), or (5). (A member of a family is the spouse, ancestor, lineal descendant, or any spouse of a lineal descendant.)
7. A corporation, partnership, trust, or estate of which (or in which) any direct or indirect owner described in (1) through (5) holds 50% or more of any of the following.
   1. The combined voting power of all classes of stock entitled to vote or the total value of shares of all classes of stock of a corporation.
   2. The capital interest or profits interest of a partnership.
   3. The beneficial interest of a trust or estate.
8. An officer, director (or an individual having powers or responsibilities similar to those of officers or directors), a 10% or more shareholder, or highly compensated employee (earning 10% or more of the yearly wages of an employer) of a person described in (3), (4), (5), or (7).
9. A 10% or more (in capital or profits) partner or joint venturer of a person described in (3), (4), (5), or (7).
10. Any disqualified person, as described in (1) through (9) above, who is a disqualified person with respect to any plan to which a section 501(c)(22) trust is permitted to make payments under section 4223 of ERISA.

In laymen’s terms, do not do any business in any shape or form with yourself, your spouse, and most of your family. There are nuances and exceptions, but you as the investor need to be mindful of who the IRA is dealing with during every transaction. When in doubt, talk to your CPA and your self-directed company for guidance.

 

Conclusion

 

SIH Capital Group’s focus is on alternative investments. On almost every investor call, the topic of self-directed retirement plans comes up. This is not a surprise, given how much investor money is tied up in traditional plans. One of our core beliefs is that alternative investments can work hand in hand with traditional investments, but one way of doing so is allocating a portion of your retirement accounts into alternative investments. Unfortunately, the largest retirement account brokerages in the country do not offer genuine alternative investment options—that’s why it’s important to understand that the options exist.

I hope this article series helps to guide you on your journey into the world of self-directed retirement accounts.

 

Disclaimer: The information presented in this article is for informational purposes only and does not constitute professional financial or investment advice. The author does not make any guarantees or promises as to the results that may be obtained from it. You should never make any investment decision without first consulting with your own financial advisor and conducting your own research and due diligence. Even though the author has made reasonable efforts to ensure that the contents of this book were correct at press time, the author disclaims all liability in the event that any information, commentary, analysis, opinions, advice and/or recommendations contained in this article result in any investment or other losses. Your use of the information in this article is at your own risk.

 

[1] https://sdirahandbook.com/ubit-udfi-taxes/ubit-tax-and-self-directed-iras-3-key-tips-every-investor-should-know/

[2] Not 100% prohibited for Solo 401k’s

[3] https://www.mysolo401k.net/investing-life-insurance-solo-401k-individual-401k-solo-k-individual-k/

[4] https://www.irs.gov/publications/p560#en_US_2020_publink10009044