An individual contacted me with concerns about his self-directed IRA. Several years ago, he invested his IRA in an LLC that acquires and renovates aging mobile home parks. Over time, the portfolio expanded significantly and now generates substantial monthly cash flow — enough to service the property-level debt and still provide a healthy income stream to investors.
Sounds good, doesn’t it? Unfortunately, there is a serious problem. No one told this investor that his IRA investment was generating Unrelated Business Taxable Income. Because the IRA owns an interest in an LLC, the IRA itself may owe income tax on the profits from the investment — taxes that, in this case, have gone unpaid for more than a decade.
Here’s how this happens.
Tax-exempt entities — including charities, churches, and IRAs — may own interests in businesses unrelated to their primary tax-exempt purpose. However, when those activities generate more than $1,000 of income in a year, the tax-exempt entity must report the income and pay tax on it.
This is where many IRA investors get tripped up. They assume that because the purpose of an IRA is to fund retirement, any income it produces must be related to that purpose. Unfortunately, the IRS disagrees.
There are two primary ways an IRA can generate Unrelated Business Taxable Income.
The first is by investing in an operating business organized as a pass-through entity, such as an LLC or limited partnership. Pass-through entities do not pay tax at the entity level; profits flow through to the owners. If one of those owners is an IRA, the income would otherwise escape taxation entirely, creating an unfair advantage over taxable competitors. As a result, the IRS treats that income as taxable to the IRA.
By contrast, an IRA can invest in a C-Corporation without generating Unrelated Business Taxable Income because the corporation itself pays income tax.
The second way an IRA can generate Unrelated Business Taxable Income is through the use of debt. When an IRA uses non-recourse financing — such as a mortgage — to acquire income-producing property, it may create Unrelated Debt-Financed Income, a subset of Unrelated Business Taxable Income. It applies because the income is generated partly by borrowed funds rather than IRA assets.
For example, suppose an IRA purchases a rental property for $300,000 using $150,000 of IRA funds and a $150,000 mortgage. Because half of the investment is debt-financed, half of the net income is treated as Unrelated Debt-Financed Income and subject to income tax inside the IRA.
UBTI and UDFI do not automatically make an investment inappropriate, but the tax consequences must be evaluated carefully. IRAs are taxed as trusts, and trust tax brackets are highly compressed. In 2023, trusts reach the top marginal tax rate of 37% at just $14,451 of taxable income. By comparison, individuals do not reach that rate until $578,125.
It is also important to remember that the IRA is a separate legal entity from the IRA owner. The tax is owed by the IRA itself — not the individual — even though the IRA owner is ultimately responsible. The IRA owner cannot reimburse the IRA for taxes paid and receives no personal tax credit for those payments.
For investors who want to use their IRA in opportunities that might otherwise generate Unrelated Business Taxable Income, a relatively straightforward planning option is inserting a C-Corporation as an intermediary. The IRA can invest in the C-Corp without triggering UBTI, and the C-Corp can then invest in the underlying business or real estate. While the C-Corp will pay income tax, it does so at the current corporate rate of 21%, which is often far more favorable than trust tax rates.
Unrelated Business Taxable Income issues are complex and frequently misunderstood. If you believe an IRA investment may be generating UBTI, it is essential to work with a financial advisor experienced in this area and to review any potential exposure with a qualified tax professional.
Steven C. Merrell is a partner and managing director at Creative Planning (formerly known as Monterey Private Wealth). He welcomes questions you may have concerning investments, taxes, retirement or estate planning. Send your questions to: Steve Merrell, 2340 Garden Road, Suite 202, Monterey, CA, 93940. Or you can email steve.merrell@creativeplanning.com. This commentary is provided for general information purposes only, should not be construed as investment, tax or legal advice, and does not constitute an attorney/client relationship. Past performance of any market results is no assurance of future performance. The information contained herein has been obtained from sources deemed reliable but is not guaranteed.
