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UBTI and UBIT in IRAs and Qualified Plans: Identifying
Unrelated Business Taxable Income and Avoiding UBTI Tax Traps
THURSDAY, AUGUST 30, 2018, 1:00-2:50 pm Eastern
FOR LIVE PROGRAM ONLY
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FOR LIVE PROGRAM ONLY
THURSDAY, AUGUST 30, 2018
UBTI and UBIT in IRAs and Qualified Plans: Identifying Unrelated Business Taxable Income and Avoiding UBTI Tax Traps
William M. Funk, Atty
Law Office of William M. Funk, New York
Bill Humphrey, Co-founder and CEO
New Direction IRA, Louisville, Colo.
James A. Jones, Founder
The IRAeXchange, Boston
Notice
ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY
THE SPEAKERS’ FIRMS TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY
OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT
MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR
RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN.
You (and your employees, representatives, or agents) may disclose to any and all persons,
without limitation, the tax treatment or tax structure, or both, of any transaction
described in the associated materials we provide to you, including, but not limited to,
any tax opinions, memoranda, or other tax analyses contained in those materials.
The information contained herein is of a general nature and based on authorities that are
subject to change. Applicability of the information to specific situations should be
determined through consultation with your tax adviser.
UBTI AND UBIT IN IRAS AND
QUALIFIED PLANS
Strafford Continuing Education Webinars
August 30, 2018
James Jones [email protected] M. Funk, Esq. [email protected] Humphrey, CPA [email protected]
James A Jones
CEO
IRAeXchange.net
CEO, Advisory Board, 2018 FiNext Award
Recipient, National Speaker, Author, Advisor on
Fintech and Finance
The IRAeXchange is the Self-Directed IRA
industry leader providing technology solutions,
resources, education and practical “know how” to
investing in alternative assets with a self-directed
IRA.
Presenter – James A Jones IRAeXchange
6
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ABOUT THE SPEAKER
▪ William M. Funk is a tax attorney with over ten years of experience working for law firms and a global accounting firm prior to opening his own practice. He has delivered highly-rated tax presentations to accountants for Continuing Professional Education credit, to attorneys for Continuing Legal Education credit, and to business professionals. He also has written numerous articles on tax issues. His current practice includes representing hedge funds, real estate businesses, individuals and nonprofits with cross-border operations. Representative transactions include structuring hedge funds, real estate joint ventures with tax-exempt organizations, U.S. investments by foreign persons and executive compensation. He received his LL.M. in Taxation from New York University Law School, his J.D. from Vanderbilt Law School and his A.B. from University of Chicago. For additional information, please visit www.funklawsite.com.
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BILL HUMPHREY, CPACEO, New Direction IRA, Inc.
Contact
New Direction IRA, Inc.
Bill Humphrey | CEO
1070 W. Century Dr. Ste. 101
Louisville, CO 80027
(p) 303-546-7930
(email) [email protected]
Bill is recognized in the industry as an expert in self-
directed IRAs, HSAs, and other tax-advantaged
accounts, as well as the IRS codes pertaining to these
investments. Bill has taught courses on retirement plan
investment rules to investors, CPAs, and investment
professionals through a variety of venues, including the
University of Denver’s School of Law.
An experienced Certified Public Accountant, Bill has
focused on income tax, auditing, tax-related real estate
issues, and forensic accounting for more than 20 years.
Bill is well versed in IRA law and is current with all
legislation governing tax-advantaged plans. Bill has
served as a consultant to HSA platform providers, and
is a leader in promoting the idea of investing HSA
assets long term for medical costs in retirement. He has
been involved in real estate investment and has
assisted in developing the framework for debt-
leveraged IRA real estate investment.
Bill received his Bachelor of Science degree in
Business from the University of North Carolina, Chapel
Hill, with a concentration in accounting and computer
science. He rounded out his technical background with
graduate study in finance, accounting, and economics
at the University of Colorado, Boulder.
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TOPICS COVERED
▪ Unrelated Business Income Tax (“UBIT”)
− Basics
− Passive Activity Exception
− Unrelated Debt Financed Income (“UDFI”)
− For-Profit Subsidiaries
− UBIT relating to Qualified Plans and IRAs
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TOPICS COVERED
▪ UBTI generating assets in IRAs and other qualified plans
▪ Self-directed IRA reporting
▪ IRA trusts and other vehicles holding UBTI assets
▪ Identifying and calculating UBTI
▪ Filing Form 990T
▪ Specific Questions
1. The panel will discuss these and other important topics:
2. What assets and structures will generate UBTI?
3. How do MLPs held by an IRA impact UBTI reporting and payment requirements?
4. What are the estimated payment rules for qualified plans with unrelated business income tax liabilities?
5. Unrelated debt-financed income rules and treatment of qualified plan assets financed by debt
6. What factors should account holders be especially aware of in cases where the plan holds UBTI-generating assets?
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UNRELATED BUSINESS INCOME TAX
▪ Entities Subject to Unrelated Business Income Tax (“UBIT”)
− Organizations generally exempt under Section 501(a)
• Charitable organizations etc.
• Special organizations such as social clubs have special twists on UBIT.
− Organizations generally exempt under Section 401(a) or 408
• Individual Retirement Accounts
• Qualified pension plans.
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UNRELATED BUSINESS INCOME TAX
▪ Elements of Application of UBIT
− Trade or Business
− Regularly Carried On
− Not Substantially Related to Exempt Function• Code Section 512
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UNRELATED BUSINESS INCOME TAX
▪ Trade or Business Analysis
− Activity carried on for production of income.
− Profit motive.
− Competition with for-profit businesses. Treas. Reg. 1.513-1(b)
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UNRELATED BUSINESS INCOME TAX
▪ Passive Income Modification
− Dividends (other than S corporations).
• Special REIT rule
• Special rule for controlled subsidiaries
− Interest
− Annuities
− Payments on Securities Lending
− Royalties
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UNRELATED BUSINESS INCOME TAX
▪ Passive Income Modification (continued)
− Rent
• Real Estate Rental
• Personal Property Associated with Real Estate
− Sale of Property
• Other than inventory or property held out for sale to customers in ordinary course of business.
− Option income
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UNRELATED BUSINESS INCOME TAX
▪ Passive Income Modification (continued)
− Passive Activities That May Be Active
• Real estate sales in sufficient quantity.
• Subpart F income attributable to insurance.
• Unusual investments.
• Rental income under certain circumstances.
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UNRELATED BUSINESS INCOME TAX
▪ Passive Income Modification (continued)
− Issues with rental income
• More than 50 percent of rent under a lease attributable to personal property.
• Rental amounts based on an equity kicker. Code Section 512(b)(3)
• Rent of premises where services rendered to occupant. Treas. Reg. 1.512(b)-1.
17
UNRELATED BUSINESS INCOME TAX
▪ Questions• What happens if an IRA or pension invests in a master
limited partnership?
• What happens if an IRA or pension invests in a fund that engages in loan origination?
• What happens if an IRA or pension invests in a hotel? An office building?
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UNRELATED DEBT-FINANCED
INCOME
▪ UBIT is imposed on Unrelated Debt-Financed Income (“UDFI”).
▪ UDFI may be generated from passive investments as well as other property.
▪ Key to analysis is “debt-financed property”. Code Section 514
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UNRELATED DEBT-FINANCED
INCOME
▪ Debt-financed property
▪ Property held to produce income.
▪ Acquisition indebtedness during the taxable year.
▪ But not to extent that use of property is substantially related to the organization’s exempt purpose.
▪ And not to extent income already accounted for in unrelated trade or business income.
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UNRELATED DEBT-FINANCED INCOME
▪ Acquisition Indebtedness
- Debt incurred “in connection with” acquisition or improvement of property.
- Includes debt that would not have been incurred but for acquisition or improvement.
- Includes debt for which need was reasonably foreseeable at time of acquisition or improvement.
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UNRELATED DEBT-FINANCED INCOME
▪ Acquisition Indebtedness
▪ Purchasing property subject to a mortgage is acquisition indebtedness. (Note: can avoid by prepayment of debt. Rev. Rul. 76-95)
▪ Liens and other encumbrances are debt for the acquisition indebtedness rules. Including margin purchases.
▪ Acquisition indebtedness of property acquired by partnership.
▪ But not debt incurred when “inherent” part of performance of exempt purpose (example, 501(c)(3) bonds).
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UNRELATED DEBT-FINANCED INCOME
▪ Acquisition Indebtedness – Special Real Estate Exception
▪ To preserve the ability of pension funds and other investors to have passive investments in real estate, certain exempt organizations may invest in real estate without being subject to UDFI.
▪ Organizations Covered (“Qualified Organizations”)
▪ Organizations exempt under Code Section 401(a)
▪ Retirement Accounts under Code Section 403(b)(9)
▪ Title-holding organizations under Code Section 501(c)(25)
▪ Educational organizations
▪ Affiliated support organizations of educational organizations.
25© Law Office of William. M. Funk 25
UNRELATED DEBT-FINANCED INCOME
▪ Special Real Estate Exception (continued)
▪ Exception is for debt incurred by a qualified organization to acquire or improve real property.
▪ Restrictions:
▪ Purchase/sale price of real property must be fixed as of date of sale (unless a purchase of foreclosure property from a financial institution).
▪ No equity-kickers: Debt obligations may not be conditioned on future income/profits/revenues from property (unless from foreclosure property purchased from a financial institution).
▪ Sale-leaseback with seller or related-party not permitted.
▪ Qualified trust may not purchase property from person related to plan under which the trust was formed.
▪ Financing by a related party must be provided on commercially reasonable terms.
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UNRELATED DEBT-FINANCED INCOME
▪ Special Real Estate Exception (continued)
▪ Application to investment through partnership.
▪ Exception available if the investment meets one of these conditions:
▪ All investors are Qualified Organizations.
▪ Qualified allocations of Code Section 168(h)(6) are met.
▪ Fractions Rule (watch the exceptions).
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UNRELATED DEBT-FINANCED INCOME
▪ Questions:
▪ Can other investors’ participation in a fund affect an IRA’s or pension’s taxation?
▪ What happens if we use debt financing to take a distribution from a fund? To finance a distribution to other investors? To buy out other investors?
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Is UBIT a Prohibited Transaction or
Illegal?
Unfamiliarity results in fear
No, it’s just a tax
The tax code does not prohibit leverage within an IRA or
Alternative Investment within a Retirement Plan
Many accountants are not familiar with it
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Publication 598
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Origins of UBIT
Qualified Pension and 401k Plans (may meet an exemption for
debt-financed investment)
Non-profits
Applies to IRAs, both Roth and Traditional
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When Does UBIT Occur ?
Debt-financed IRA/Qualified Plan purchases
Operating a business within an IRA
Sale of debt-leveraged property
Owning a pass-through (untaxed) entity operating a business *
* IRAs are not eligible S – Corp
shareholders although 401ks and
other Qualified plans are.
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A Tax By Any Other Name…
UBIT
Unrelated Business
Income Tax
UBTI
Unrelated Business
Taxable Income
UDFI
Unrelated Debt
Financed Income
Same or Different?
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Rental IncomeUntaxed
Business Income
UBIT
Sale of
Debt-Leveraged
UDFIUDFI
Subject to U B I T
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Working Definition - UDFI
On net income after deductions (including depreciation)
Only on the % of net income attributed to debt-financing
Applies to sale of property based on debt financed portion
Applies to rental income from real property
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Other UBIT / UDFI Facts
• Yes, but securities create the same issue because they pay
taxes before your IRA received dividends
Who pays the tax bill?• The IRA/Qualified Plan pays the tax bill
When are tax payments necessary?• If the IRA/Qualified Plan generates taxable net income over
$1,000
• Frequently no tax bill for the first 5 to 8 years due to depreciation
Isn’t that double taxation?
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UBIT FactsBased on ratio of 12
month avg. loan balance
to depreciated basis of
property At sale taxed at unrecap.
sect 1250 gain & rest cap
gains rate (debt financed
portion) Operating income taxed
using Trust rate (debt
financed portion only)
401(k) and Qualified
Pension Plans may be
exempt Always “run the numbers”
on case by case basis
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Form 1065 Schedule K-1
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Form 1065 Schedule K-1
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How much UBIT will be paid?
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Calculated at trust rate:
Only on income “brought in”
by extra buying power of debt
Extra
Income35% MAX
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IRA calculates rental income just like an
individual would
▪ Income
▪ Less expenses
− Taxes
− Insurance
− Management
− Interest
− Operating
− And Tax Depreciation
▪ = Net Rental Income
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Tax depreciation is used for tax
calculation
41
IRA/Qualified Plan reports only debt
financed portion as income
Average Debt Balance
Divided by
Average Adjusted Basis
Debt Financed % X Net Rental Income = UBI
42
NOL carries forward to subsequent
years
43
A quick example
▪ Covers income from rental operations
▪ Covers sale of property
44
John’s IRA buys an investment property using a non-
recourse loan:
Cost of Property: $ 500,000
IRA Investment: $ 200,000
Non-recourse Loan: $ 300,000
Leverage: 60%
Mortgage Payment: $ 1,600 / month
Taxes & Insurance: $ 400 / month
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Other Information:
Rent: $ 2,500 / month
Utilities: Paid by tenant
Net Cash Flow:$490 / month = $5,874 /
year
Depreciation: $14,545 / year
Interest Expense: $ 14,720 (4.95%)
Net Loss Year One: ($4,265)
Annual Appreciation: 2.5%
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Year 8
Rent: $ 2,951 / month, T&I $475
Utilities: Paid by tenant
Net Cash Flow:$876 / month = $10,512 /
year
Depreciation: $14,545 / year
Principal Payments: $ 6,318
Interest Expense: $12,876
Net Income Year Eight: $2,296
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Calculation of UBIT on Year 8’s Income:
Debt Balance / Depreciated
Basis:
$ 263,835 / $398,182 =
66.26%
Net Income x 66.26%: $ 1,521
UBI $ 1,521 - $1,000 = $521
Tax: ~ $104
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Calculation of UBIT On Sale in Year 8:
Sale Price: $ 609,201
Costs of Sale (3%): $ 18,276
Net Proceeds: $ 590,925
Current Year Debt-
Financed %:66.26%
Capital Gain ($590,925 -
$426,587):$ 164,338
UBI Portion: $108,757
UBIT: $ 23,665
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Account Value
0
50,000
100,000
150,000
200,000
250,000
300,000
350,000
400,000
Year 1 Year 8
Debt Financed RealEstate IRA
Annual Return =12.1%
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FOR-PROFIT SUBSIDIARIES
▪ Reasons for establishing for-profit subsidiaries.
▪ Preserving assets of one set of operations against liabilities of other set of obligations.
▪ Clarifying missions of business managers and other managers.
▪ Cleaner accounting and tax reporting.
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FOR-PROFIT SUBSIDIARIES
▪ Taxation
▪ Dividends from for-profit subsidiary are exempt as passive income.
▪ Interest, annuities, royalties and rents from for-profit subsidiaries are potentially subject to UBIT. Code Section 512(b)(13)
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FOR-PROFIT SUBSIDIARIES
Which for-profit subsidiaries are subject to special rules of Code Section 512(b)(13)?
For a corporation, ownership by vote or value of 50 percent of more of stock.
Constructive ownership rules of Code Section 318 apply.
Amount subject to UBIT is an amount equivalent to the reduction in taxable income of the for-profit subsidiary.
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UNRELATED BUSINESS INCOME TAX
COMPUTATION
▪ Computing UBIT
▪ Taxed at corporate tax rates. Currently 21 percent.
▪ For exempt organizations with more than one taxable business, under the Tax Cuts and Jobs Act of 2017 must compute unincorporated business taxable income separately.
▪ No netting across lines of business.
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UNRELATED BUSINESS INCOME TAX
COMPUTATION
▪ Computing UBIT
▪ Expenses directly connected with the trade or business are deductible.
▪ Proximate and primary relationship
▪ Expenses of mixed-purpose activities must be allocated on a reasonable basis.
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UNRELATED DEBT-FINANCED INCOME
▪ Computing UDFI
▪ Not all income from debt-financed property is UDFI.
▪ Based on debt/basis percentage.
− Average acquisition indebtedness for year divided by average basis of debt-financed property.
− Based on principal indebtedness on first day of every month of taxable year.
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UNRELATED DEBT-FINANCED INCOME
▪ Computing UDFI
▪ Allowable deductions are also based on debt/basis percentage.
− NB: Depreciation of property permitted only on straight-line basis. Code Section 514(a)(3).
▪ Special rules for gain or loss on disposition of property.
− Required to use highest amount of acquisition indebtedness for 12-month period before disposition of property.
▪ K-1, Line 20, Code V and Statements.
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UBIT ESTIMATED TAXES
▪ Estimated Taxes
▪ Quarterly payments are required to be paid with the Form 990-W.
▪ Due dates are April 15, June 15, September 15 and December 15.
▪ Failure to pay estimated tax results in an interest charge at the underpayment interest rate.
Filling Out the 990T
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Sample – debt leveraged
rental property532000
X
X
X
50,750 42,370
42,37050,750 8,380
8,380
Special Tax ID
Page 1 Part 1
61
Page 1 Part 2
20,513
20,513
8,380
8,380
1,000
7,380
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x 1,752
1,752
1,752
1,752
1,752
0
0
Page 2 Part 3
63
Page 2 Part 5
x
x
x
x
64
Page 3
65
Page 3 – Schedule E
72,500 40,01520,513
700,000 50,750 42,370
42,37050,750
1,000,000 70%
RENTAL PROPERTY
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Page 4 of 4 - N/A
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Debt financed percentage is tracked by
property
Average Debt Balance
Divided by
Average Adjusted Basis
Average Debt Balance
Divided by
Average Adjusted Basis
Average Debt Balance
Divided by
Average Adjusted Basis
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Debt payoff can be directed to specific
loans
69
Taxes on gains rolled into subsequent
properties may be avoided/reduced
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May occur at the sale
of the property
Key Points - IRAs
Is only charged on the
debt leveraged
portion of the net
income
May occur when there
is taxable rental
operating income
over $1,000
Is not against the
rules
Should be considered
as another expense
when doing your rate
of return analysis
May carry forward
losses to offset future
income
UBIT
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Should you leverage your IRA to make a Real
Estate Purchase?
Rental Income &
Vacancy Operating ExpensesReserves for
Contingencies
% Loan to Value Bank Terms Future Appreciation
Do the calculations.
Look at:
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How to Avoid UBIT from UDFI
Pay off debt 12 months before you sell the property
Do not leverage property
Offset taxable gains with losses
Do a 1031 Exchange within the IRA
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CONTACT INFORMATION
William M. Funk, Esq.
Law Office of William M. Funk
275 Madison Avenue, 11th Floor
New York, NY 10016
Phone: (212) 973-1100
Fax: (917) 210-3513
E-mail: [email protected]
www.funklawsite.com
New Direction IRA
1070 W. Century Dr.
Suite 101
Louisville, CO 80027
303/546-7930
www.NewDirectionIRA.com75