UBTI -- When Does It Apply to Real Estate Transactions?

With the popularity of investing with self-directed IRAs at an all-time high, there is a strong possibility that you or someone you know will be using retirement funds to purchase real estate, invest in loans, buy a business, or invest in other “nontraditional” investments. Self-directed IRA holders have a vastly increased number of investment options available to them than those with IRA funds invested at a traditional brokerage house.

One important factor that impacts the investment choices of self-directed IRA investors, however, is Unrelated Business Taxable Income or UBIT. Often overlooked or misunderstood, UBIT is a special tax that Congress created to apply to tax-exempt entities that produce income from business activity rather than from “passive” investments. In addition to churches, charities and non-profits, IRAs can also be subject to UBIT.

The majority of self-directed IRA investments are considered passive investments, including; interest from loans, dividends from securities, real estate rental incomes and the proceeds of the sale of real estate that was held for appreciation. These types of investments are exempt from UBIT.

The types of income that could subject an IRA to UBIT are those earned from the sale of a product or service, whether retail or wholesale and regardless of ownership percentage. Where self-directed IRA investors are most likely to encounter UBIT is in certain types of real estate projects. 

A self-directed IRA investor would most commonly face UBIT on the profits generated from rehab/flips or development /construction projects that result from a resale. In contrast, incomes from properties purchased for appreciation and/or rental incomes are exempt from taxation in an IRA, unless the property is purchased on leverage (which is an entirely different topic and won’t be covered in this article). The area where investors, and often their tax advisors, get confused is in determining which projects produce passive tax-exempt income and which produce business income where UBIT would apply.

The IRS and the tax courts use a series of tests to determine if an activity is a passive investment or a business activity. There are up to 10 factors that can be considered. No factor is more important than the other, and no one factor is determinative. Here are some of the most common tests used:  

• Intent – Did the individual buy the property with the intent to hold it for appreciation? Or did the individual buy the property to resell it quickly? If the intent was to hold it for appreciation, this is a strong indication that it is an investment and not taxable to the IRA. If the intent was for resale, then there is a strong likelihood that the activity will be deemed a business and taxable to the IRA.
  • Development or Construction – In general, development and construction are considered activities that are designed to increase the value of the asset through action as opposed to appreciation. Development or construction activities imply that the investment project is business-related and therefore taxable in the IRA.

• Holding Period – The longer the property is held from either the original purchase or from the completion of development or construction, the less likely the income will be subject to UBTI when it is eventually sold. In most cases, one year from the completion of development/construction is considered the minimum length of time the property should be held to offset the business factors of development/construction activities– but that must be discussed with a qualified tax professional.

• Marketing – Marketing activities include any activities that are designed to attract a potential buyer. The longer you advertise and the more aggressive the marketing, the more likely your investment will be considered a business and will be subject to UBTI.

• Inventory Replacement – If your IRA sells an asset and then replaces that asset with another similar asset to be sold, this is holding the property only as inventory. The more rapid or frequent the replacement and resale cycle, the more likely it is that UBTI taxes will apply.

If you are considering, or already have a self-directed IRA, it is encouraged to consult your qualified tax professional to gain a better understanding of the potential tax implications. Even for the vast majority of investments that incur UBIT, the benefits of the self-directed IRA investment will outweigh tax implications.  Your tax advisor may be able to identify other factors to consider with your specific IRA situation, and realizing these factors should enable you to realize even greater financing benefits.