Can Your IRA Become A Tax Payer? | Unrelated Business Income Tax

Today, we’re going to  talk about what happens when an IRA becomes a taxpayer, or more importantly, why an IRA might become a taxpayer.

An IRA Paying Taxes? How Does That Happen?

Now, you may be thinking: “I have never even heard the words, IRA and taxes in the same sentence before. That’s okay, because IRAs, 401ks, HSAs, and ESAs are all tax exempt entities.

This is in the sense that they do completely eliminate capital gains tax. And they allow you to invest and get the power of compounding interest going a little bit more aggressively than making those same types of investments outside of a tax sheltered investment vehicle.

And you may have investments inside of those accounts that trigger taxation – though it might not be something you want to hear – it is simply something to be aware of and not scared of.

Unrelated Business Income Tax

UBTI, UBIT, UDFI – What Do They Mean?

So for today, we will be talking about a few acronyms, starting with something called “unrelated business income tax” or UBIT for short.

But there’s also UBTI and UDFI. Don’t worry, we’ll break them down for you.

UBTI means unrelated business taxable income. It’s a type of income generated by a business that’s taxable. 

UBIT or unrelated business income tax is the tax that’s generated because of the business’s income. 

UDFI, is a type of UBTI, and it stands for “unrelated debt finance tax.” It is a type of income that – in the eyes of the IRS – is taxable if it applies to certain IRA investments. 

These acronyms all work hand-in-hand, but the important thing to remember is that there is income that can be generated from an IRA’s investments that could be taxable

The IRS looks at tax-sheltered investment vehicles like IRAs, wanting to level the playing field should that tax sheltered entity operate a business, or bring in leverage like outside money from that tax shelter to fulfill investments.

How Your IRA Might Owe Taxes

There are two different ways that your IRA could become a taxpayer:

  1. If your IRA owns an operating business. 
  • Business income from that investment might be taxed because the IRS looks to level the playing field. For example, someone could be operating a hamburger shop inside of an IRA right across the street from a McDonald’s and undercut them till the cows come home.
  1. If the IRA owner brings in money from outside of their tax sheltered account and uses it to increase their buying power, thus making their investments debt-leveraged.
  • Now the IRS recognizes the money used to help make the investments inside of your IRA as coming from outside the protection of the tax sheltered vehicle.

To them, this means that you didn’t contribute those dollars per the contribution limits year over year. And since those dollars exist outside of a tax shelter, a portion of the income generated, or the proceeds from the sale of that investment will be taxable. 

Here’s an example of how all that works:

  1. You use a loan to purchase a rental property.
  1. Whatever your debt-financed percentage of the initial investment will be the same percentage applied to the income generated or the proceeds from sale.
  1. You will then pay taxes on the debt-financed percentage of income. This is what the IRS deems to have been financed by your loan, or money that came from outside your IRA.

How To Use Tax Write-Offs Inside Of Your IRA

So while your IRA does become a taxpayer, in some situations, just know that there is some silver lining. You could very likely use write-offs now that your IRA has become a taxpayer. 

Think again about the example of bringing in outside money – using debt leverage – to finance an investment purchase like a rental property, and you’re able to pay that loan down a little bit each month. 

The lower the loan, the lower the taxes.

As you pay off the loan, you will shrink the debt-financed percentage of the investment’s resulting income. That means that the taxes your IRA is responsible for also get smaller and smaller as the initial loan gets paid down.

How Do You Know?

So, how do you figure out if your investment type might trigger UDFI (in the case of a loan) or UBTI?

This is a topic that comes up a lot with self-directed IRAs, and we at NuView are very well equipped to let you know what you might be looking at. 

If you want to know if a specific investment structure might trigger this type of taxation, we’re a good first resource, but we are not tax professionals, or any kind of tax, investment, or financial advisor. 

This being said – especially with specific numbers – we always, always, always, recommend talking to a CPA. We recently held a fantastic webinar with CPA Adam Barr, and he went into such great detail on this topic. 

Again, the topic of IRAs paying taxes is one that most people don’t know much about, so his in-depth explanation is a much-needed educational resource. Most folks don’t ever expect to hear “IRA” and “taxes” in the same sentence, so we strongly encourage you to check it out. 

At the same time, Adam Barr himself is an excellent resource if you do have an investment in a SDIRA that could trigger this type of taxation. He’ll be able to help you figure out what that tax responsibility is and how to pay it.

Always Learn More

UBIT, UDFI, and UBTI are all different acronyms that are all related to each other, and we at NuView understand that this is a fairly complicated topic in the IRA world.

 If you want to learn a little bit more about these terms, definitely give us a call for more information. And be sure to check out our recent webinar discussion with Adam Barr CPA. 

There’s a lot of investments out there and a lot of opportunity with investing inside of your IRA. So having good foundational knowledge is key, that way you’re better prepared to use leverage and use your SDIRA for the powerful tool that it is

Like always, thanks for checking us out. If you have any questions, contact us at NuView.

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