By Anthony Diosdi
The appeal of investing retirement funds outside of the typical investments has driven a surge in the use of self-directed Individual Retirement Account (“IRA”) investment structures. Investments within self-directed IRAs frequently include real estate, closely held business entities, private loans, and can include any other investment that is not specifically prohibited by federal law. In my last blog, I discussed the legal implications of investing in a self-directed IRA. This blog I will discuss potential tax obligations and filing requirements associated with self-directed IRAs.
Most individuals who fund a self-directed IRAs do not realize that funding such a structure may trigger tax obligations and filing requirements. Anyone considering funding a self-directed IRA must understand the term unrelated business taxable income (“UBTI”). If the self-directed IRA earns UBTI, the IRA may need to file a Form 990-T and pay annual taxes. In addition, if the self-directed IRA utilizes non-recourse debt to acquire property, the self-directed IRA may be subject to Unrelated Debt Financing Tax (“UBFI”) tax. Below, please find two illustrations which demonstrate how the aforementioned taxes and filing requirements apply to self-directed IRAs.
Illustration 1.
Jill invested $500,000 from her IRA into an LLC custom jewelry company. The investment gave Jill a 25 percent interest in an LLC. The LLC had three other owners, not related to Jill, and none of the other investors were co-owners with her in any other business entities. Jill was not involved in the LLC’s day-to-day operations and did not otherwise personally benefit from the investment.
The LLC recorded a significant profit on its annual Form 1065, U.S. Partnership Income Tax Return. In turn, each investor, including Jill’s self-directed IRA was issued yearly Schedules K-1, Partner’s Share of Income, Deductions, Credits, etc., which showed ordinary income. In Jill’s case, the K-1 forms were mailed directly to the company that established Jill’s self-directed IRA. The company that formed the self-directed IRA ignored the K-1 forms.
Jill was unaware of Internal Revenue Code Section 512. This Internal Revenue Code imposes a tax on income earned by a tax-exempt organization in a trade or business that is unrelated to the organization’s exempt purpose. This type of tax liability is known as UBTI and it became a large problem for Jill.
Most IRA investments do not trigger current tax consequences, not because all income an IRA earns grows tax free, but because the types of income that an IRA typically earns are exempt from UBTI tax rules. For example, IRAs that invest in publicly traded securities (e.g., stocks, bonds, and mutual funds) do not owe current tax because gains from the sale of C corporation stock dividends, and interest income are exempt from UBTI. For this reason, most IRA investors are unaware that an IRA can require a tax return (Form 990-T Exempt Organization Business Income Tax Return) and pay taxes. Income from a business that is regularly carried on (whether directly or indirectly) can result in UBTI and filing requirements.
In this case, since the LLC Jill invested into conducted a regularly conducted business, the self-directed IRA had a tax consequence. To make matters worse, in Jill’s case, the self-directed IRA was taxed at trust rates. This resulted in Jill’s self-directed IRA realizing a far greater tax liability compared to an individual who is taxed at ordinary marginal tax rates. Jill was shocked to discover, five years into the LLC’s operation, that her self-directed IRA not only owed significant back taxes on the LLC’s yearly profits, but the tax rate on income over $12,750 was a whopping 37 percent. To add insult to injury, there was an additional net investment income tax of 3.8 percent assessed on the trust income over $12,750. Although Jill’s self-directed IRA benefited from the investment income, the self-directed IRA owed significant income tax, penalties, and interest which eliminated any benefit of utilizing a self-directed IRA.
Several factors contributed to Jill’s failure to comply with her tax obligations. First, Jill was unaware of and uninformed about the self-directed IRA legal and tax issues. Second, as is typically the case, the IRA custodian refuses to take any responsibility and includes language with its IRA custodian agreement stating that all legal tax consequences of the self-directed investments are the IRA account holder’s sole responsibility. In fact, it is common for IRA custodians to receive tax documents and send copies to the self-directed IRA owner without mentioning the potential UBTI tax consequences.
Illustration 2.
Mark, had $1.5 million in his 401(k). Mark decided to invest the $1.5 million in a self-directed IRA. Mark’s goal for his self-directed IRA was to invest in residential real estate through an LLC. Mark found a real estate investment group that frequently organized partnerships and promised “passive” investment (no direct involvement by Mark). The real estate partnership collected capital contributions from 20 investors and used the cash plus debt to purchase an apartment building. The apartment building was held as a rental property, with net income distributed to the investors, including Mark’s self-directed IRA LLC.
As stated above, it is possible for a self-directed IRA to invest in a broad range of investments. Thus, real estate partnerships are acceptable self-directed IRA investments is technically correct. However, this does not answer the question of whether there are more difficult legal or tax issues. For example, “rent from real property” is normally exempt from UBTI, and thus currently not taxable when earned by a self-directed IRA or self-directed IRA LLC. However, income from debt-financed property (whether held directly or indirectly by the self-directed IRA or self-directed IRA LLC) is partially taxable under the UDFI rules because the income generated from the investment is not earned by investment of the self-directed IRA capital, but rather by financing.
In this case, the yearly income that is allocated to Mark’s self-directed LLC is partially subject to tax under the UDFI rules. Income received from debt-financed property may be subject to the UDFI rules. Because the property placed in the self-directed IRA was financed and subject to the UDFI rules, the self-directed IRA was required to file Form 990-T, annually. This was the case whether or not UDFI taxes was required to be paid. Failure to pay the UDFI taxes and file Form 990-T could subject Mark’s self-directed IRA to significant penalties and interest.
Anyone considering funding a self-directed IRA must understand the tax consequences and filing requirements associated with their particular situation. To avoid disastrous consequences this should be done before funding a self-directed IRA.
The tax attorneys at Diosdi Ching & Liu, LLP represent clients in a wide variety of domestic and international tax planning and tax controversy cases.
Anthony Diosdi is a partner and attorney at Diosdi Ching & Liu, LLP, located in San Francisco, California. Diosdi Ching & Liu, LLP also has offices in Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi represents clients in federal tax controversy matters and federal white-collar criminal defense throughout the United States. Anthony Diosdi may be reached at (415) 318-3990 or by email: adiosdi@sftaxcounsel.com.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.