SD-IRAs and UBIT (unrelated business tax income)

Updated by Sanjay Vora

One of the questions Avestor gets quite often is what is the impact of unrelated business tax income (UBIT) and unrelated debt financed income (UDFI) on investors in a fund that have an SD-IRA account. While Avestor is not a tax expert and fund managers should consult their own CPAs and tax preparers for information specific to their fund, we can provide some high level thoughts around this.

First, lets start with the definition of UBIT.

Unrelated business taxable income (UBTI) is income earned by a tax-exempt entity that's not related to the tax-exempt purpose of the entity. More precisely, the Internal Revenue Service (IRS) defines unrelated business taxable income for most organizations as "income from a trade or business, regularly carried on, that is not substantially related to the charitable, educational, or other purpose that is the basis of the organization's exemption."

Activities That Generate UBTI

An activity is considered unrelated business (and the income generated taxable) if it meets the following thresholds, as defined by the IRS:

  • It is a trade or business that produces income from selling goods or performing services.
  • It is regularly carried on in a way that's similar to the commercial activities of nonexempt organizations.
  • It is not substantially related to furthering the exempt purpose of the organization. Activities that generate income must play a major role in achieving an organization's tax-exempt purpose to be substantially related.

Some transactions that may be considered unrelated business activity include:

  • Buying and selling a significant number of real estate properties in a year.
  • Conducting operations in businesses—such as restaurants, convenience stores, lodging inns, or gas stations—that generate active income and are operated through a pass-through entity such as a limited liability company (LLC).

Source: IRS website and Wikipedia

So the question comes up, if an investor creates an SD-IRA account within a fund, will there be significant UBIT income that will result in the SD-IRA having to pay UBIT.

Here is Avestor's view point on this topic.

  • Most real estate investments pass through losses, not gains during their operating years due to expenses and depreciation. If there is a real estate loss, there is no UBIT gains and potentially UBIT losses on an investor K-1.
  • All distributions to investors, such as preferred returns, are not taxable, until all of the investor's original capital investment has been returned. They just change the capital account balance associated with that specific investment.
  • At exit, if there is a sale, then there could but UBIT gains that flow through. If the SD-IRA custodian filled otu the proper IRS forms and claimed the UBIT losses in prior years, those losses can offset the UBIT gains to minimize the tax impact.

To check if there is UBIT flowing through on your fund's investment, fund managers can look for K1 Box 20, Code V. In most cases, you won't see a Code V so no UBIT was recorded or you will see a negative number which is the loss.

When the property is sold, you will see the capital gains from the sale flow through. A majority of the time, it flows through as 1231 and 1250 gains (boxes 9c and 10) on the K1. If they do record a portion as UBTI, yes that portion would be taxable at that time.

For most investors in customizable funds, the investment amounts are small per deal ($50k-$100k) so UBIT income may not be substantial. If an SD-IRA investor is concerned, fund managers should recommend that when the investor receives their K1, they should check for Box 20V. If there are losses, ask the investor to ensure that their custodian records the loss in Form 990-T that they file with the IRS. Then those earlier year 20V losses will offset and 20V gain they get at exit of the deal.

In summary, Avestor believes that investors will benefit by having their SD-IRA investments in alternative investments like real estate and not fear the tax impact. The benefits of investing in real estate investments will offset the impact of paying taxes.

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